CREDIT ANALYSIS

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CREDIT ANALYSIS

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1. 1 CREDIT ANALYSIS Office of Small and Disadvantaged Business Utilization Department of Transportation Introduce Introduce Instructor Introduce each Attendee Name, Bank, Responsibility, What you hope to learn. Review materials provided: Copy of Slides Wire Binder - reference material List of Participants 8:30 A.M.Introduce Introduce Instructor Introduce each Attendee Name, Bank, Responsibility, What you hope to learn. Review materials provided: Copy of Slides Wire Binder - reference material List of Participants 8:30 A.M.

2. 2 Introductory Course ? Certified Credit Analyst Learning depends on your: Knowledge and experience Asking questions Flipchart - W - What’s I - In I - It F - For M - Me SBA expects careful analysis Therefore - Goal is to improve credit analysis Note: If one bad loan can be avoided, cost of the training is paid for. 8:40 A.M.Introductory Course ? Certified Credit Analyst Learning depends on your: Knowledge and experience Asking questions Flipchart - W - What’s I - In I - It F - For M - Me SBA expects careful analysis Therefore - Goal is to improve credit analysis Note: If one bad loan can be avoided, cost of the training is paid for. 8:40 A.M.

3. 3 Course Objectives: Introduction to Credit Tools of Financial Analysis Working Capital Analysis Cash Flow and Repayment Ability Analysis of Collateral Analysis of Equity Gain an understanding of: Perspective of SBA Tools of credit analysis Role of working capital Cash flow and Repayment ability Role of Collateral Importance of financial stake by owners How to analyze a new business Dealing with change of ownership Policy issues on debt repayment Page “0” 8:50 A.M. Gain an understanding of: Perspective of SBA Tools of credit analysis Role of working capital Cash flow and Repayment ability Role of Collateral Importance of financial stake by owners How to analyze a new business Dealing with change of ownership Policy issues on debt repayment Page “0” 8:50 A.M.

4. 4 ? What to Avoid ? Giving Money Away “Giving the Disabled a Walking Stick” Flipchart )( (Hourglass) Bankable Cream of the Crap Crap Flipchart )( (Hourglass) Bankable Cream of the Crap Crap

5. 5 Objective One Introduction to Credit

6. 6 Concept of Term Credit Viability of Loan Purpose First Way Out Second Way Out Viability: Events that give rise to the need to borrow Understood by the borrower Make sense in context of the management, economy, industry and environment First (and most important) way out Predictable cash flow from operations Profitability Payment-ability - Debt service coverage. Second way out Collateral with reasonable value Control-ability of these assets Convert-ability Pages 1-2 9:05 A.M.Viability: Events that give rise to the need to borrow Understood by the borrower Make sense in context of the management, economy, industry and environment First (and most important) way out Predictable cash flow from operations Profitability Payment-ability - Debt service coverage. Second way out Collateral with reasonable value Control-ability of these assets Convert-ability Pages 1-2 9:05 A.M.

7. 7 Elements of Business Plan Marketing or Sales Acquisition Production Distribution Finance Management Where they expect to be in the future. Four primary questions: How they market How they procure resources How they produce How they distribution Two additional elements: How they propose to finance How will management use funding Simple questions - complicated answers Business owner must be able to answer questions P. 2-3 9:08 A.M.Where they expect to be in the future. Four primary questions: How they market How they procure resources How they produce How they distribution Two additional elements: How they propose to finance How will management use funding Simple questions - complicated answers Business owner must be able to answer questions P. 2-3 9:08 A.M.

8. 8 Marketing What is being sold? Who are the customers? What is done with it? Where are they buying now? Why will they buy from this firm? Customer industry - i.e. trucking versus retail Geographic areas - local, regional, national or international Need for product - White-out example Limitations of market potential - Beaver restaurant Is service or product in demand?Customer industry - i.e. trucking versus retail Geographic areas - local, regional, national or international Need for product - White-out example Limitations of market potential - Beaver restaurant Is service or product in demand?

9. 9 Acquisition What resources are needed? Are these available? How will they be obtained? What is the cost? Resources required to obtain business: materials, physical assets, human assets? Are these resources readily available or limited in source? How will the firm obtain these resources? Does the firm have Just In Time delivery Are long time frames required (Jamaica manufacturer needs for raw materials and problems of quantity) What are the costs of these resources? 9:15 A.M.Resources required to obtain business: materials, physical assets, human assets? Are these resources readily available or limited in source? How will the firm obtain these resources? Does the firm have Just In Time delivery Are long time frames required (Jamaica manufacturer needs for raw materials and problems of quantity) What are the costs of these resources? 9:15 A.M.

10. 10 Production What is the technology? What are the fixed assets needed? What are the labor needs? What are the costs? What constraints are present? What is the technology employed? Is it subject to obsolescence? Is it state of the art? What are the fixed asset requirements for this business? Are adequate fiscal assets available? Are the assets relatively new or well depreciated? Is trained labor available? What are the training requirements for new employees? What constraints are there on production? Is the location suitable? Are there environmental risks? Are there government constraints (licenses, etc.)? 9:17 A.M.What is the technology employed? Is it subject to obsolescence? Is it state of the art? What are the fixed asset requirements for this business? Are adequate fiscal assets available? Are the assets relatively new or well depreciated? Is trained labor available? What are the training requirements for new employees? What constraints are there on production? Is the location suitable? Are there environmental risks? Are there government constraints (licenses, etc.)? 9:17 A.M.

11. 11 Distribution How does the customer obtain? Why will they use this firm? What are the storage needs? How customer obtains product Requirements to deliver service Transportation problems? Location problems? Delivery systems? Costs of delivery? How do the competitors reach the customer? What are the constraints on delivery? Just in Time delivery? Warehousing requirements? Transportation requirements? What distribution problems have you seen?How customer obtains product Requirements to deliver service Transportation problems? Location problems? Delivery systems? Costs of delivery? How do the competitors reach the customer? What are the constraints on delivery? Just in Time delivery? Warehousing requirements? Transportation requirements? What distribution problems have you seen?

12. 12 Finance How much money is needed? What are the sources? What are the costs? What is the return to equity? “Grease that makes the wheels of the business turn.” How much is needed? What is it needed for? What are the sources of financing? Do the owners have a significant financial stake? Are outside financing sources utilized? What are the needs of the owners? What is their life style? Is the rate of return on the owners’ stake adequate for the risk involved? If return is low, are the owners “irrational” enough to keep the business alive? 9:25 A.M.“Grease that makes the wheels of the business turn.” How much is needed? What is it needed for? What are the sources of financing? Do the owners have a significant financial stake? Are outside financing sources utilized? What are the needs of the owners? What is their life style? Is the rate of return on the owners’ stake adequate for the risk involved? If return is low, are the owners “irrational” enough to keep the business alive? 9:25 A.M.

13. 13 Management Who are the principals? What is their experience? What are their money needs? Why will they be successful? Who will operate the business? What is their experience & training? Is it related? Is there adequate management depth? Why do the principals believe they will be successful and be able to repay the loan? What are their strengths? Who will operate the business? What is their experience & training? Is it related? Is there adequate management depth? Why do the principals believe they will be successful and be able to repay the loan? What are their strengths?

14. 14 Objective Two Tools of Financial Analysis Accounting Concepts Balance Sheet Adjustments Ratio Analysis Break-Even Analysis Common Size 9:50 A.M. 9:50 A.M.

15. 15 Financial Statements Balance Sheet Income Statement Statement of Cash Flow Major tool of analysis Balance Sheet - summarize financial position of the business at a point in time Income Statement - results of operations for the period as shown Statement of Cash Flow - flow of cash through the balance sheet and income statement. Accountant prepared statements include all three statements. Internally prepared statements require need to develop statement of cash flows.Major tool of analysis Balance Sheet - summarize financial position of the business at a point in time Income Statement - results of operations for the period as shown Statement of Cash Flow - flow of cash through the balance sheet and income statement. Accountant prepared statements include all three statements. Internally prepared statements require need to develop statement of cash flows.

16. 16 Accountant Prepared Compilation Review Audit Compilation - Representation of management without expressing any assurance. “Accordingly, these financial statements are not designed for those who are not informed about such matters”. The loan officer is the user and must interpret them. Review - Accountant prepares from books and records of the company and performs inquiry and procedures to obtain a reasonable basis for a limited assurance that there are no material modifications needed. Audit - Requires certain specific tests of procedures and accounts so the accountant can express an opinion. An audit may be unqualified or qualified because of limited scope, not in accordance with GAAP, or future uncertainties 9:33 A.M.Compilation - Representation of management without expressing any assurance. “Accordingly, these financial statements are not designed for those who are not informed about such matters”. The loan officer is the user and must interpret them. Review - Accountant prepares from books and records of the company and performs inquiry and procedures to obtain a reasonable basis for a limited assurance that there are no material modifications needed. Audit - Requires certain specific tests of procedures and accounts so the accountant can express an opinion. An audit may be unqualified or qualified because of limited scope, not in accordance with GAAP, or future uncertainties 9:33 A.M.

17. 17 Dynamics of Credit Economy Seasonality Type of Business Prestige vs. Essential Business is on-going and subject to the environment Economic Environment in which the firm operates, local, regional or national. Success may be dependent on economic trends. Economic environment also impacted by competition. Is another restaurant appropriate in the market area? What are the risks of additional similar firms operating in the same environment? Seasonality. Seasonal businesses need line of credit program. Industry A manufacturer competing directly with much larger firms serving a large market (clothing) will have different risks than a locally oriented business (sawmill). Diversity In the product or service provided or in the number of customers and/or suppliers. Greater diversity means less risk Staple vs.. Prestige. Is the product or service a necessity that has a ready market or an impulse that can be postponedBusiness is on-going and subject to the environment Economic Environment in which the firm operates, local, regional or national. Success may be dependent on economic trends. Economic environment also impacted by competition. Is another restaurant appropriate in the market area? What are the risks of additional similar firms operating in the same environment? Seasonality. Seasonal businesses need line of credit program. Industry A manufacturer competing directly with much larger firms serving a large market (clothing) will have different risks than a locally oriented business (sawmill). Diversity In the product or service provided or in the number of customers and/or suppliers. Greater diversity means less risk Staple vs.. Prestige. Is the product or service a necessity that has a ready market or an impulse that can be postponed

18. 18 Limitations of Financial Statements Management Responsibility Value of Accounts Receivable Inventory Valuation Fixed Asset Valuation Off Balance Sheet Accounts F/S are the responsibility of management. F/S are historical and developed on a cost basis. Loan officer is concerned with accurate values of the assets & liabilities and future operations of the business. Management believes that all receivables are collectible and may not provide any reserve. Bad Debts are written off only when it is deemed necessary usually only at the end of the year if then. Inventory valuation method impacts balance sheet operating profit. FIFO can lead to understated COGS and overstated OP. LIFO may provide reasonable income statement but can under value assets on the balance sheet. Fixed Asset value depends on management's allocation of the useful life. Depreciation is often a part of cash flow and the method of determining depreciation expense can give a false sense of adequacy of cash flow Business may lease assets. Business requires asset for operation but it may not be on the balance sheet. The loan officer must adjust the financial statements to reflect the true picture.F/S are the responsibility of management. F/S are historical and developed on a cost basis. Loan officer is concerned with accurate values of the assets & liabilities and future operations of the business. Management believes that all receivables are collectible and may not provide any reserve. Bad Debts are written off only when it is deemed necessary usually only at the end of the year if then. Inventory valuation method impacts balance sheet operating profit. FIFO can lead to understated COGS and overstated OP. LIFO may provide reasonable income statement but can under value assets on the balance sheet. Fixed Asset value depends on management's allocation of the useful life. Depreciation is often a part of cash flow and the method of determining depreciation expense can give a false sense of adequacy of cash flow Business may lease assets. Business requires asset for operation but it may not be on the balance sheet. The loan officer must adjust the financial statements to reflect the true picture.

19. 19 What is Financial Analysis? Art, Not Science Principles and Concepts Seek Information Calculate Relationships Compare to a Norm Diagnose Health Crisis management is the norm in small business. Financial health is ignored until some sort of heart attack occurs. Just as one gets a medical checkup regularly, it is important to monitor the financial health of our clients.The financial analyst uses various techniques to assess the health of the firm. Visit to the doctor: Provide data on your health and describe your symptoms. Doctor reviews data, ask questions, does a hands on inspection and takes laboratory samples for testing. Visit to the bank: Gather data and discuss needs Develop observations of business, walk through the plant, ask questions, discuss elements with the management, and perform mathematical analysis of information from the accounting and operations records. Crisis management is the norm in small business. Financial health is ignored until some sort of heart attack occurs. Just as one gets a medical checkup regularly, it is important to monitor the financial health of our clients.The financial analyst uses various techniques to assess the health of the firm. Visit to the doctor: Provide data on your health and describe your symptoms. Doctor reviews data, ask questions, does a hands on inspection and takes laboratory samples for testing. Visit to the bank: Gather data and discuss needs Develop observations of business, walk through the plant, ask questions, discuss elements with the management, and perform mathematical analysis of information from the accounting and operations records.

20. 20 Principle of Normative Behavior Small firms operate within a normal range of conditions Deviations from the norm require explanation and treatment Successful firms are within the norm The Principle of Normative Behavior. Most similar firms operate within a range of normal conditions that cannot be deviated from if it is to be successful. Financial analysts: Looks for deviations from an industry norm Seek explanation & understanding of deviations Interpret what problems exist and what can be done to improve the situation. In a competitive environment, successful firms tend to the normal operational patterns. We call these norms “ratios”. Weaknesses - Source of information (RMA), Size of database, Fit of business to industry Glance at Standard Heating and Air Conditioning 10:20 A.M.The Principle of Normative Behavior. Most similar firms operate within a range of normal conditions that cannot be deviated from if it is to be successful. Financial analysts: Looks for deviations from an industry norm Seek explanation & understanding of deviations Interpret what problems exist and what can be done to improve the situation. In a competitive environment, successful firms tend to the normal operational patterns. We call these norms “ratios”. Weaknesses - Source of information (RMA), Size of database, Fit of business to industry Glance at Standard Heating and Air Conditioning 10:20 A.M.

21. 21 Analytical Tools Balance Sheet Adjustments Ratios Break-Even Analysis Common Size Analysis Operating Capital Analysis Cash Flow Analysis SBA requires pro-forma balance sheet (adjustments to assets & liabilities). Ratios are compared to a standard or norm for firms of similar size in the same industry. A break-even point can be calculated to identify the level of sales required to cover all pre-tax costs. It is useful in the determination of the health of the business. Financial analyst creates “common size” F/S. B/S as percent of total assets Income statement as a percent of net sales. Common size analysis reveals significant changes in the firm's operation over different time periods Operating Capital = Cash + A/R + Inv - A/P. Cash cycle in terms of the net days of sales and also in dollar terms. Positive cash flow from operations is needed to survive and prosper. The analysis of the sources and uses of cash by the business is a useful concept both for the health of the business and for the comfort of the creditors..SBA requires pro-forma balance sheet (adjustments to assets & liabilities). Ratios are compared to a standard or norm for firms of similar size in the same industry. A break-even point can be calculated to identify the level of sales required to cover all pre-tax costs. It is useful in the determination of the health of the business. Financial analyst creates “common size” F/S. B/S as percent of total assets Income statement as a percent of net sales. Common size analysis reveals significant changes in the firm's operation over different time periods Operating Capital = Cash + A/R + Inv - A/P. Cash cycle in terms of the net days of sales and also in dollar terms. Positive cash flow from operations is needed to survive and prosper. The analysis of the sources and uses of cash by the business is a useful concept both for the health of the business and for the comfort of the creditors..

22. 22 Balance Sheet Adjustments Cash Accounts Receivable Notes Receivable Inventory Investments Intangibles Debt Notes Payable Undervalued Assets Off Balance Sheet Why Balance Sheet adjustments? To correctly evaluate strength To eliminate worthless assets To account for contingent liabilities 10:30 A.M.Why Balance Sheet adjustments? To correctly evaluate strength To eliminate worthless assets To account for contingent liabilities 10:30 A.M.

23. 23 Cash Adjustments Sufficient for Operations Compensating Balances Cash is frequently at a minimum level. Are there any restrictions? Requirement to maintain a compensating balances Are there any escrow requirements? Are any deposits noted as liabilities? While this cash may be available for use, the lender should be aware of any restrictions.Cash is frequently at a minimum level. Are there any restrictions? Requirement to maintain a compensating balances Are there any escrow requirements? Are any deposits noted as liabilities? While this cash may be available for use, the lender should be aware of any restrictions.

24. 24 Accounts Receivable Collectibility Aging Adjustment A/R usually the gross amount outstanding. Small firms do not set up reserves for bad debt Some unwilling to recognize losses. Require an aging of the accounts. Eliminate any account over 90 days old Evaluate an customer over 10% of total Adjustment is a credit to accounts receivable and a debit to net worth.A/R usually the gross amount outstanding. Small firms do not set up reserves for bad debt Some unwilling to recognize losses. Require an aging of the accounts. Eliminate any account over 90 days old Evaluate an customer over 10% of total Adjustment is a credit to accounts receivable and a debit to net worth.

25. 25 Notes Receivable Related to Accounts Insider Notes Adjustment Determine if they should be carried as current assets or as other assets. Determine the nature of such accounts. Did they arise from conversion of bad A/R? Are they loans to owners or insiders? Do they indicate that the firm cannot show profits and the owner/insider forgoes a salary? These are can distort Profits from current or prior years. These should be moved to non-current assets. Some N/R are not collectible, and should be credited to asset and debited to net worth. 11:00 A.M.Determine if they should be carried as current assets or as other assets. Determine the nature of such accounts. Did they arise from conversion of bad A/R? Are they loans to owners or insiders? Do they indicate that the firm cannot show profits and the owner/insider forgoes a salary? These are can distort Profits from current or prior years. These should be moved to non-current assets. Some N/R are not collectible, and should be credited to asset and debited to net worth. 11:00 A.M.

26. 26 Inventory Unsaleable Goods Obsolete Inventory Adjustment Can be most risky valuation (SWAG) and Most difficult to determine adjustments Indicator: Low inventory turnover Loan officer should inspect for obsolete inventory. Applicant always assume that all inventory can be sold at a higher price than the book value. Where possible, loan officer should determine amount and value of obsolete inventory and credit the asset and debit net worth. Can be most risky valuation (SWAG) and Most difficult to determine adjustments Indicator: Low inventory turnover Loan officer should inspect for obsolete inventory. Applicant always assume that all inventory can be sold at a higher price than the book value. Where possible, loan officer should determine amount and value of obsolete inventory and credit the asset and debit net worth.

27. 27 Investments Nature Affiliates Adjustment Why would a small firm with limited funds make investments in other than the business? Nature of the investment should be determined. Is it needed for the business? Is it a shell company or an affiliated firm? What is the true value of such an investment? Generally, such investments have no true value. The adjustment is to credit the investment account and debit net worth.Why would a small firm with limited funds make investments in other than the business? Nature of the investment should be determined. Is it needed for the business? Is it a shell company or an affiliated firm? What is the true value of such an investment? Generally, such investments have no true value. The adjustment is to credit the investment account and debit net worth.

28. 28 Intangibles Patents and Copyrights Business Purchase Non-Compete Value of Customers Goodwill Adjustment Intangibles are aside from hard assets and have dubious value. May include: Patents and copyrights with difficult to determine values. Goodwill resulting from the purchase of the business. Non-compete agreements, Value of patient list or customer goodwill, etc. Most intangibles have little or no value for pro-forma balance sheet purposes. Caution: A write down of intangibles may greatly or totally wipe out equity. The loan officer must make a judgement on the true value of the intangible. The adjustment is to credit the intangibles and debit net worth.Intangibles are aside from hard assets and have dubious value. May include: Patents and copyrights with difficult to determine values. Goodwill resulting from the purchase of the business. Non-compete agreements, Value of patient list or customer goodwill, etc. Most intangibles have little or no value for pro-forma balance sheet purposes. Caution: A write down of intangibles may greatly or totally wipe out equity. The loan officer must make a judgement on the true value of the intangible. The adjustment is to credit the intangibles and debit net worth.

29. 29 Indebtedness Current Portion Long Term Portion Loans Payable to Insiders Adjustments Need is to clearly understand total liabilities. Must determine Current Portion of Long-term Debt The current ratio would be more accurate. Notes payable to owners/insiders are a way they financed the business. Why? To avoid taxes on withdrawal of investment To take precedence to other financing Loan officer should Consider the indebtedness subordinate (on standby) to SBA loan Consider the amount of the loan as equity The adjustment would be to debit the loan to owner/insiders and credit net worth.Need is to clearly understand total liabilities. Must determine Current Portion of Long-term Debt The current ratio would be more accurate. Notes payable to owners/insiders are a way they financed the business. Why? To avoid taxes on withdrawal of investment To take precedence to other financing Loan officer should Consider the indebtedness subordinate (on standby) to SBA loan Consider the amount of the loan as equity The adjustment would be to debit the loan to owner/insiders and credit net worth.

30. 30 Undervalued Assets Book Value vs. Market Value Real Estate Normally Adjustment Most common adjustment Real Estate is most common Fixed assets that have been depreciated May have low values on the balance sheet. Market value may be significantly greater. Market value of depreciated assets may be used to improve the net worth. SBA requires that market value is supported by an independent appraisal. The adjustment is to debit the asset on the books and credit net worth. 11:10 A.M.Most common adjustment Real Estate is most common Fixed assets that have been depreciated May have low values on the balance sheet. Market value may be significantly greater. Market value of depreciated assets may be used to improve the net worth. SBA requires that market value is supported by an independent appraisal. The adjustment is to debit the asset on the books and credit net worth. 11:10 A.M.

31. 31 Off Balance Sheet Accounts Required Assets Financing Decision Leases Adjustment Certain assets may be obtained by purchase or by leasing A legitimate financing decision. GAAP - lease may be: Capital lease - requires showing the value of the asset and the corresponding indebtedness on the balance sheet. Operating lease - not reflected in the assets or liabilities. Operating lease - Value of asset & liability should be adjusted to the pro-forma balance sheet Must determine: Maturity of the lease, interest rate used, and cash flow requirements discounted to the present. Rough rule of thumb for capitalization - multiply the lease payment expense by a factor of 5. This implies a remaining life of 8 years and a 12% interest rate.Certain assets may be obtained by purchase or by leasing A legitimate financing decision. GAAP - lease may be: Capital lease - requires showing the value of the asset and the corresponding indebtedness on the balance sheet. Operating lease - not reflected in the assets or liabilities. Operating lease - Value of asset & liability should be adjusted to the pro-forma balance sheet Must determine: Maturity of the lease, interest rate used, and cash flow requirements discounted to the present. Rough rule of thumb for capitalization - multiply the lease payment expense by a factor of 5. This implies a remaining life of 8 years and a 12% interest rate.

32. 32 EXERCISE - PROFORMA Green Enterprises Develop a Pro-forma Balance Sheet Make adjustments as per discussion Prepare Notes describing adjustments Divide class into groups at tables Handout copies of Form or Discuss Headings Each team make adjustments with Notes May finish problem before or after lunch to keep awake Adjourn to Lunch 12:00 A.M.Divide class into groups at tables Handout copies of Form or Discuss Headings Each team make adjustments with Notes May finish problem before or after lunch to keep awake Adjourn to Lunch 12:00 A.M.

33. 33 Categories of Ratios Liquidity Coverage Leverage Operating Robert Morris classifies ratios into four categories: Liquidity - These ratios measure the ability of the firm to meet is current obligations from the current assets Coverage - these ratios measure the ability of the firm to generate from its operations the funds to pay interest and principal due from current operations Leverage - these ratios measure the relationship of the creditors interest to the owners interest Operating - These ratios measure how the firm is utilizing the assets to generate profitable salesRobert Morris classifies ratios into four categories: Liquidity - These ratios measure the ability of the firm to meet is current obligations from the current assets Coverage - these ratios measure the ability of the firm to generate from its operations the funds to pay interest and principal due from current operations Leverage - these ratios measure the relationship of the creditors interest to the owners interest Operating - These ratios measure how the firm is utilizing the assets to generate profitable sales

34. 34 Liquidity Ratios Current Ratio Quick Ratio Accounts Receivable Turnover Inventory Turnover Accounts Payable Turnover Sales to Working Capital These ratios are used to measure the firms liquidity and ability to meet obligations. With all of these ratios, they represent a snapshot at a given time For seasonal companies, ratios could be badly distorted. Descriptions on the following slides.These ratios are used to measure the firms liquidity and ability to meet obligations. With all of these ratios, they represent a snapshot at a given time For seasonal companies, ratios could be badly distorted. Descriptions on the following slides.

35. 35 Current Ratio Current Assets Current Liabilities Rough measure of the firm’s ability to meet its current obligations. A general barometer of working capital adequacy. Calculated by dividing the current assets by the current liabilities. The higher the ratio, the better within limits. The ratio depends upon the quality of the assets that make up the current assets. Excess receivables or obsolete inventory can distort the reading.. Rough measure of the firm’s ability to meet its current obligations. A general barometer of working capital adequacy. Calculated by dividing the current assets by the current liabilities. The higher the ratio, the better within limits. The ratio depends upon the quality of the assets that make up the current assets. Excess receivables or obsolete inventory can distort the reading..

36. 36 Quick Ratio Cash plus Receivables Current Liabilities Quick or Acid Test Ratio reflects only the value of the truly liquid assets and ignores the assets with lower liquidity such as inventory. Lenders have difficulty in evaluating inventory because of a lack of specialized knowledge of its market value. Most small business operate with minimum cash and this ratio reflects the value in the receivables. This ratio can be distorted if the firm has excessive accounts receivable.Quick or Acid Test Ratio reflects only the value of the truly liquid assets and ignores the assets with lower liquidity such as inventory. Lenders have difficulty in evaluating inventory because of a lack of specialized knowledge of its market value. Most small business operate with minimum cash and this ratio reflects the value in the receivables. This ratio can be distorted if the firm has excessive accounts receivable.

37. 37 Accounts Receivable Turnover Net Sales Accounts Receivable Convert to Days Accounts Receivable/(Net Sales/365) Accounts Receivable turnover measures the number of times the receivables are collected during the year. By converting the ratio to days, we determine the number of days from a sale to collection (Collection Period). A low turnover (or high number of days) in relation to the industry median, may reflect considerable delinquent accounts. This may be because of lenient collection policies or it may mean the firm is accepting customers who have poor credit. Accounts Receivable turnover measures the number of times the receivables are collected during the year. By converting the ratio to days, we determine the number of days from a sale to collection (Collection Period). A low turnover (or high number of days) in relation to the industry median, may reflect considerable delinquent accounts. This may be because of lenient collection policies or it may mean the firm is accepting customers who have poor credit.

38. 38 Inventory Turnover Cost of Goods Sold Inventory Convert to Days Inventory/(COGS/365) Inventory Turnover reflects the number of times the inventory is sold during the year. High turnover may indicate a liquid inventory stock and good inventory management. Too high a ratio may reflect the loss of sales due to lack of stock and back orders. It also may reflect the inability of the firm to obtain adequate supplies of goods from its suppliers. Low inventory turnover may reflect obsolete or redundant inventory held by the firm; and that a significant amount of inventory held is unsaleable. Inventory Turnover reflects the number of times the inventory is sold during the year. High turnover may indicate a liquid inventory stock and good inventory management. Too high a ratio may reflect the loss of sales due to lack of stock and back orders. It also may reflect the inability of the firm to obtain adequate supplies of goods from its suppliers. Low inventory turnover may reflect obsolete or redundant inventory held by the firm; and that a significant amount of inventory held is unsaleable.

39. 39 Accounts Payable Turnover Cost of Goods Sold Accounts Payable Convert to Days Accounts Payable/(COGS/365) Accounts Payable Turnover reflects the timing of the payment to the suppliers for goods purchased. A low ratio in relation to the industry will reflect the inability of the firm to generate cash to meet its obligations to suppliers and is termed “leaning on” or “riding” the trade. Consistent late payment of outstanding payables to vendors will erode supplier relationships. Because a firm must obtain goods for resale or for inclusion in a product, it is critical that supplier relationships be maintained. Accounts Payable Turnover reflects the timing of the payment to the suppliers for goods purchased. A low ratio in relation to the industry will reflect the inability of the firm to generate cash to meet its obligations to suppliers and is termed “leaning on” or “riding” the trade. Consistent late payment of outstanding payables to vendors will erode supplier relationships. Because a firm must obtain goods for resale or for inclusion in a product, it is critical that supplier relationships be maintained.

40. 40 Sales to Working Capital Net Sales Working Capital Sales to Working Capital is another liquidity ratio obtained by dividing net sales by the net working capital (current assets - current liabilities). This ratio is an indicator of liquidity strength. A low ratio may suggest an inefficient utilization of working capital. There is less cushion to protect the short term creditors. Exercise 1 Calculate the liquidity ratios for 1997 for Standard Heating and Air Conditioning and compare to RMA. Interpret the resultSales to Working Capital is another liquidity ratio obtained by dividing net sales by the net working capital (current assets - current liabilities). This ratio is an indicator of liquidity strength. A low ratio may suggest an inefficient utilization of working capital. There is less cushion to protect the short term creditors. Exercise 1 Calculate the liquidity ratios for 1997 for Standard Heating and Air Conditioning and compare to RMA. Interpret the result

41. 41 EXERCISE ONE Calculate the liquidity ratios for Berry Latest Year Compare to RMA Interpret the Results Re-divide class into groups at different tables? Re-divide class into groups at different tables?

42. 42 Current Ratio Berry Current Assets = 1279.8 = 1.4 Current Liabilities 897.9 RMA 1.4 . For purposes of analysis we will use the The RMA median is 1.4 RMA obtains financial information from its member banks and separates the businesses according to NAICS categories. RMA calculates all the ratios we will discuss for each firm in each industry, and arrays the result from the lowest to the highest. The middle firm is the median, and the upper quartile and lower quartile are also determined. In some industries RMA has a large number of firms; in others only a few. The number of firms in each industry is reflected in the RMA data. In Berry,the current ratio over the first two years was at the low ratio, and in the most current year is at the median. At this point, do we have any cause for concern? We will need to evaluate the assets making up the current assets.. For purposes of analysis we will use the The RMA median is 1.4 RMA obtains financial information from its member banks and separates the businesses according to NAICS categories. RMA calculates all the ratios we will discuss for each firm in each industry, and arrays the result from the lowest to the highest. The middle firm is the median, and the upper quartile and lower quartile are also determined. In some industries RMA has a large number of firms; in others only a few. The number of firms in each industry is reflected in the RMA data. In Berry,the current ratio over the first two years was at the low ratio, and in the most current year is at the median. At this point, do we have any cause for concern? We will need to evaluate the assets making up the current assets.

43. 43 Quick Ratio Berry Cash plus Receivables=5.8+196.9 =0.22 Current Liabilities 897.9 RMA 0.4 This ratio should have a value of at least 1 since there is a need to liquidate inventory to meet short term credit. At a rate of 0.22, Berry does not have significant liquidity. The RMA median for fuel oil distributors is 0.4 Berrys quick ratio has been relatively stable over the three years and at 0.2 is at the lower quartile. What does this ratio tell you? Assuming the receivables are at true value, does a creditor have a reasonable expectation of being paid on time.? It is a=obvious from these two ratios, that the inventory is a significant amount. The creditor would have to be assured that the inventory will turn over rapidly to generate sufficient cash to pay the bills. This ratio should have a value of at least 1 since there is a need to liquidate inventory to meet short term credit. At a rate of 0.22, Berry does not have significant liquidity. The RMA median for fuel oil distributors is 0.4 Berrys quick ratio has been relatively stable over the three years and at 0.2 is at the lower quartile. What does this ratio tell you? Assuming the receivables are at true value, does a creditor have a reasonable expectation of being paid on time.? It is a=obvious from these two ratios, that the inventory is a significant amount. The creditor would have to be assured that the inventory will turn over rapidly to generate sufficient cash to pay the bills.

44. 44 Accounts Receivable Turnover Berry Net Sales = 2643.1 = 13.4 Accounts Receivable 196.9 Convert to Days 196.9 = 27.2 AR/(Net Sales/365) 2643.1/365 RMA 12.9 28 Days RMA median ratio is 12.9 - A/R turnover for Berry is 13.4 slightly above the median Expressed in days, the company takes 27.2 days to collect vs a slightly greater 28 days for the median. The company’s ratio lies between the median and the upper quartile. What does this mean? The company appears to have a good collection policy and selects its customers carefully. The ratio has been relatively constant at 12.5, 11.1 and 13.4. . Loose credit and collection policy Marginal customers denied credit by competitors. Some portion of receivables are not collectible. Lack of attention to collections RMA median ratio is 12.9 - A/R turnover for Berry is 13.4 slightly above the median Expressed in days, the company takes 27.2 days to collect vs a slightly greater 28 days for the median. The company’s ratio lies between the median and the upper quartile. What does this mean? The company appears to have a good collection policy and selects its customers carefully. The ratio has been relatively constant at 12.5, 11.1 and 13.4. . Loose credit and collection policy Marginal customers denied credit by competitors. Some portion of receivables are not collectible. Lack of attention to collections

45. 45 Inventory Turnover Berry Cost of Goods Sold = 1894.8 = 2.1 Inventory 898.1 Convert to Days = 898.1 =173 Inventory/(COGS/365) 1894.1/365 RMA 3.8 98 Days RMA median is 3.8 Berry has consistent ratio of 2.3, 2.3 and 2.1 Inventory turnover is lower that then lower quartile of the industry. Do we have any reason to be concerned with the inventory management?. Because of the nature of the business, and the low ratios, there is some concern with the saleability of some of the inventory. Is there obsolete inventory carried on the books that cannot be sold? Days of inventory were 151, 159 and 173 or a deterioration in the ability to move inventory. In all three years, the days of inventory were below the lower quartile.RMA median is 3.8 Berry has consistent ratio of 2.3, 2.3 and 2.1 Inventory turnover is lower that then lower quartile of the industry. Do we have any reason to be concerned with the inventory management?. Because of the nature of the business, and the low ratios, there is some concern with the saleability of some of the inventory. Is there obsolete inventory carried on the books that cannot be sold? Days of inventory were 151, 159 and 173 or a deterioration in the ability to move inventory. In all three years, the days of inventory were below the lower quartile.

46. 46 Accounts Payable Turnover Berry Cost of Goods Sold = 1894.8 = 10.1 Accounts Payable 187.6 Convert to Days = 187.60 =36.1 AP/(COGS/365) 1894.8/365 RMA 15.6 23 Days RMA median Accounts Payable Turnover is 15.6 Berry turnover is 10.1 well below the turnover at the median. In the three years the turnover was 12.4, 11.7 and 10.1 all just slightly above the lower quartile of 9.1 Days were 29, 31 and 36, a deteriorating situation. When a firm has an inventory problem, it cannot generate cash and thus has to lean on the suppliers (leaning or riding the trade). What does this mean” SHAI requires cash for operations SHAI extend its suppliers. If it cannot collect from its customers it cannot obtain cash to pay its suppliers. Conclusion: Inadequate attention to management of working capital. (Particularly at the collection of receivables) Poor management of cash may translate into poor management of the firm. We need to take a look at the efficiency of management overallRMA median Accounts Payable Turnover is 15.6 Berry turnover is 10.1 well below the turnover at the median. In the three years the turnover was 12.4, 11.7 and 10.1 all just slightly above the lower quartile of 9.1 Days were 29, 31 and 36, a deteriorating situation. When a firm has an inventory problem, it cannot generate cash and thus has to lean on the suppliers (leaning or riding the trade). What does this mean” SHAI requires cash for operations SHAI extend its suppliers. If it cannot collect from its customers it cannot obtain cash to pay its suppliers. Conclusion: Inadequate attention to management of working capital. (Particularly at the collection of receivables) Poor management of cash may translate into poor management of the firm. We need to take a look at the efficiency of management overall

47. 47 Sales to Working Capital Berry Net Sales = 2643.1 = 6.9 Working Capital 1279.8-897.9 RMA 10.6 RMA median is 10.6 Berry is 6.9 above the industry median. Why? Excessive inventory skews the ratio. The ratio has deteriorated from 12.9, 11.4, 6.9 Sales increased by $211.0; Working Capital increased by 114.0. If we assume that some of the inventory is cannot be sold at the carrying price, we may have a significant working capital problem. Because of the excess accounts receivable the working capital appears to be higher than it really is. Conclusion: Firm is not efficient in utilizing its working capital. In relation to the doctor, we know the patient is ill, and we have identified one area of concern; working capital management. We must continue to examine the situation before we can prescribe treatmentRMA median is 10.6 Berry is 6.9 above the industry median. Why? Excessive inventory skews the ratio. The ratio has deteriorated from 12.9, 11.4, 6.9 Sales increased by $211.0; Working Capital increased by 114.0. If we assume that some of the inventory is cannot be sold at the carrying price, we may have a significant working capital problem. Because of the excess accounts receivable the working capital appears to be higher than it really is. Conclusion: Firm is not efficient in utilizing its working capital. In relation to the doctor, we know the patient is ill, and we have identified one area of concern; working capital management. We must continue to examine the situation before we can prescribe treatment

48. 48 Coverage Ratios Times Interest Earned Current Maturity Coverage Two ratios reflect the ability of the firm to meet its obligations to outside creditors Times Interest Earned measures the generation of earnings over and above the interest cost of debt Current Maturity Coverage measures the ability of the firm to pay immediately due principal page 32 2:00 P.M.Two ratios reflect the ability of the firm to meet its obligations to outside creditors Times Interest Earned measures the generation of earnings over and above the interest cost of debt Current Maturity Coverage measures the ability of the firm to pay immediately due principal page 32 2:00 P.M.

49. 49 Times Interest Earned EBIT Interest EBIT = Earnings before payment of interest and income taxes This ratio measures the ability to make payments of interest from operational activity. A high number indicates adequate debt capacity A low ratio may indicate too much debt for the earning power of the assets. Generally, a ratio of at least 3 is desired Indicates that the firm generates earnings before the payment of interest and taxes that is three times the amount of interest expense. . EBIT = Earnings before payment of interest and income taxes This ratio measures the ability to make payments of interest from operational activity. A high number indicates adequate debt capacity A low ratio may indicate too much debt for the earning power of the assets. Generally, a ratio of at least 3 is desired Indicates that the firm generates earnings before the payment of interest and taxes that is three times the amount of interest expense. .

50. 50 Current Maturity Coverage NP + Depreciation + Amortization Current Portion LTD Measure ability of the firm to pay outstanding principal. Equals all cash flow elements from the income statement divided by the CPLTD. A high number indicates adequate debt capacity. A low number indicates difficulty in meeting obligations. If less than 1, company unable to meet obligations and must substitute other sources of debt for maturing debt. Desirable ratio would be three or better. Indicates that cash generated from operations is significantly higher than debt service required. 2:30 P.M.Measure ability of the firm to pay outstanding principal. Equals all cash flow elements from the income statement divided by the CPLTD. A high number indicates adequate debt capacity. A low number indicates difficulty in meeting obligations. If less than 1, company unable to meet obligations and must substitute other sources of debt for maturing debt. Desirable ratio would be three or better. Indicates that cash generated from operations is significantly higher than debt service required. 2:30 P.M.

51. 51 Leverage Ratios Fixed Assets to Net Worth Debt to Net Worth Measure the financial risk. Firms with high leverage (large debt in relation to net worth) are vulnerable to the ebbs and flows of economic cycles. The leverage depends on the type of industry. Page 33 2:35 P.M. Measure the financial risk. Firms with high leverage (large debt in relation to net worth) are vulnerable to the ebbs and flows of economic cycles. The leverage depends on the type of industry. Page 33 2:35 P.M.

52. 52 Fixed Assets to Net Worth Fixed Assets Tangible Net Worth Indicates extent that owners’ funds are invested in the fixed assets. Premise - the longest lived funds should cover the the longest lived assets. Low number provides a safer situation in the event of forced liquidation. High ratio might indicate that creditors are poorly protected by the equity of the business. Leased property may not appear on the balance sheet, giving a false signal. It is appropriate to restate the balance sheet to reflect the value of leased assets. Calculate for SHAIIndicates extent that owners’ funds are invested in the fixed assets. Premise - the longest lived funds should cover the the longest lived assets. Low number provides a safer situation in the event of forced liquidation. High ratio might indicate that creditors are poorly protected by the equity of the business. Leased property may not appear on the balance sheet, giving a false signal. It is appropriate to restate the balance sheet to reflect the value of leased assets. Calculate for SHAI

53. 53 Debt to Tangible Net Worth Total Liabilities Tangible Net Worth Calculated by dividing all liabilities by the net worth of the firm. Measures capital structure: Relative interest of creditors and owners. Higher ratio = more leverage = greater risk to creditors. Some industries with stable cash flows can utilize greater leverage. Calculate for SHAI Page 34Calculated by dividing all liabilities by the net worth of the firm. Measures capital structure: Relative interest of creditors and owners. Higher ratio = more leverage = greater risk to creditors. Some industries with stable cash flows can utilize greater leverage. Calculate for SHAI Page 34

54. 54 EXERCISE TWO & THREE Calculate ratios for Berry Interest Coverage Current Maturity Coverage Fixed Assets/Tangible Net Worth Total Liabilities/Tangible N/W

55. 55 Times Interest Earned Berry EBIT = 120.6 = 1.8 Interest 66.4 RMA 2.3 Median for the industry is 2.3 Berry had a ratio of 1.8 that is between the lower quartile and the median.. It has improved slightly over the periods Interest expense remained relatively stable over the years, from 1.5, 1.2 to 1.8Median for the industry is 2.3 Berry had a ratio of 1.8 that is between the lower quartile and the median.. It has improved slightly over the periods Interest expense remained relatively stable over the years, from 1.5, 1.2 to 1.8

56. 56 Current Maturity Coverage Berry NP+Depreciation+Amort=47.3+26.4=1.1 Current Portion LTD 64.4 RMA 2.9 Median is 2.9 Berry ratio is 0.7, 0.6 and 1.1, all below the lower quartile.. Concerns? The company has developed a serious cash problem. The ratio as calculated does not include the significant indebtedness under Notes Payable, that are from a line of credit. In the first two years it did not generate sufficient cash from operations to pay its short term principal to creditors. Long term installment notes payable have increased rapidly over the period. Where is Berry getting the cash? Why would a lender make a long term loan to this business in the latest year?. Median is 2.9 Berry ratio is 0.7, 0.6 and 1.1, all below the lower quartile.. Concerns? The company has developed a serious cash problem. The ratio as calculated does not include the significant indebtedness under Notes Payable, that are from a line of credit. In the first two years it did not generate sufficient cash from operations to pay its short term principal to creditors. Long term installment notes payable have increased rapidly over the period. Where is Berry getting the cash? Why would a lender make a long term loan to this business in the latest year?.

57. 57 Fixed Assets to Net Worth Berry Fixed Assets = 208.4 = 0.5 Tangible Net Worth 463.1-28.1 RMA 1.0 Tangible net worth is the equity of the business less the intangible value that is probably worthless. Median ratio for RMA is 1.0 Berry is way below the comparable at 0.5 that has remained constant over the periods, What does this mean? The firm has a disproportionate amount of funds devoted to current assets. It also may reflect that the plant is aging and will need replacing. (Heavy depreciation) What do you anticipate is the age of the trucks and delivery equipment? Tangible net worth is the equity of the business less the intangible value that is probably worthless. Median ratio for RMA is 1.0 Berry is way below the comparable at 0.5 that has remained constant over the periods, What does this mean? The firm has a disproportionate amount of funds devoted to current assets. It also may reflect that the plant is aging and will need replacing. (Heavy depreciation) What do you anticipate is the age of the trucks and delivery equipment?

58. 58 Debt to Tangible Net Worth Berry Total Liabilities = 1096.6 = 2.4 Tangible Net Worth 435 RMA 1.9 RMA median ratio is 2.3. SHAI ratio in 1994 is 2.3, declining to 1.5 in 1996. What does this mean? Leverage is lower than industry. High proportion of CPLTD may indicate shortness of the obligations. As reflected in the fixed assets to tangible net worth, the firm is not replacing its aging plant. Relatively poor performance in management of working capital may extend to management of fixed assets. We may see poor performance in the operating ratios as well. RMA median ratio is 2.3. SHAI ratio in 1994 is 2.3, declining to 1.5 in 1996. What does this mean? Leverage is lower than industry. High proportion of CPLTD may indicate shortness of the obligations. As reflected in the fixed assets to tangible net worth, the firm is not replacing its aging plant. Relatively poor performance in management of working capital may extend to management of fixed assets. We may see poor performance in the operating ratios as well.

59. 59 Operating Ratios Profit to Net Worth Profit to Total Assets Gross Profit Margin Operating Profit Margin Fixed Asset Turnover Total Asset Turnover Owners Compensation to Sales Operating ratios measure managerial performance. Generally these ratios use profitability as the measure. Operating ratios measure managerial performance. Generally these ratios use profitability as the measure.

60. 60 Profit to Tangible Net Worth Profit Before Tax Tangible Net Worth Measures return on the tangible investment by owners. Calculated by dividing profit before taxes by net worth. Rate of return should be sufficient to justify the investment in the operating assets. What does it mean? High ratio indicates good management of assets. Could indicate failure to take advantage of other investment opportunities in its industry. Low ratio may mean ineffective management or inefficient utilization of assets. This ratio can be broken into several elements: (on flip chart) PBT x EBIT x NS x TA = PBT EBIT NS TA TNW TNW Earnings x Operating Profit x Asset Turnover x Asset Leverage = Return on EquityMeasures return on the tangible investment by owners. Calculated by dividing profit before taxes by net worth. Rate of return should be sufficient to justify the investment in the operating assets. What does it mean? High ratio indicates good management of assets. Could indicate failure to take advantage of other investment opportunities in its industry. Low ratio may mean ineffective management or inefficient utilization of assets. This ratio can be broken into several elements: (on flip chart) PBT x EBIT x NS x TA = PBT EBIT NS TA TNW TNW Earnings x Operating Profit x Asset Turnover x Asset Leverage = Return on Equity

61. 61 Profit to Total Assets Profit Before Tax Total Assets Calculated = Profit before tax divided by total assets. Variation on return on investment. Measures the effectiveness of management in using the assets to produce profit. Can have significant variation from year to year. A heavily depreciated plant may result in a very high figure which does not indicate management effectiveness. New investment in technology may lead to a very low figure when management is building a platform for future generation of income. In small firms, the numbers may be relatively small and vary widely from year to year. It may be appropriate in these situations to take a multiple year average.Calculated = Profit before tax divided by total assets. Variation on return on investment. Measures the effectiveness of management in using the assets to produce profit. Can have significant variation from year to year. A heavily depreciated plant may result in a very high figure which does not indicate management effectiveness. New investment in technology may lead to a very low figure when management is building a platform for future generation of income. In small firms, the numbers may be relatively small and vary widely from year to year. It may be appropriate in these situations to take a multiple year average.

62. 62 Gross Profit Margin Gross Profit Net Sales Calculated = gross profit divided by the net sales. Gross profit margin measures: Pricing competitiveness Manufacturing or service efficiency. Measures ability to sell the product or service at a sufficient margin to cover fixed costs and provide a residual profit to owners. What does it mean? High ratio can mean a price structure above the average or a cost structure below the average. Above average pricing may require additional services leading to higher operating costs. Converse is also true; a company may use a low price strategy with lower operating costs to reach customers with lower service expectations. Consider the difference between Wal-Mart and Neiman Marcus. Page 36 3:10 P.M.Calculated = gross profit divided by the net sales. Gross profit margin measures: Pricing competitiveness Manufacturing or service efficiency. Measures ability to sell the product or service at a sufficient margin to cover fixed costs and provide a residual profit to owners. What does it mean? High ratio can mean a price structure above the average or a cost structure below the average. Above average pricing may require additional services leading to higher operating costs. Converse is also true; a company may use a low price strategy with lower operating costs to reach customers with lower service expectations. Consider the difference between Wal-Mart and Neiman Marcus. Page 36 3:10 P.M.

63. 63 Operating Profit Margin Operating Profit Net Sales Calculated = Earnings before interest and taxes divided by net sales. Operating profit is the amount of sales value remaining after all operating costs except interest. A firm must have a positive operating profit to survive. Operating profit must be sufficient to meet the obligations to outside creditors and to provide owners with a return on their investment. Calculated = Earnings before interest and taxes divided by net sales. Operating profit is the amount of sales value remaining after all operating costs except interest. A firm must have a positive operating profit to survive. Operating profit must be sufficient to meet the obligations to outside creditors and to provide owners with a return on their investment.

64. 64 Net Profit Margin Profit before Tax Net Sales The so called bottom line. What the company earns from the The so called bottom line. What the company earns from the

65. 65 Fixed Asset Turnover Net Sales Fixed Assets Calculated = Net sales divided by net fixed assets. Measure efficiency of the investment in fixed assets. Reflects the number of sales dollars generated by each dollar invested in fixed assets. A firm requires a certain level of fixed assets to generate a certain level of sales. Higher ratio may reflect a highly depreciated plant or a failure to invest in new more efficient fixed assets. Calculated = Net sales divided by net fixed assets. Measure efficiency of the investment in fixed assets. Reflects the number of sales dollars generated by each dollar invested in fixed assets. A firm requires a certain level of fixed assets to generate a certain level of sales. Higher ratio may reflect a highly depreciated plant or a failure to invest in new more efficient fixed assets.

66. 66 Total Asset Turnover Net Sales Total Assets Calculation = Net sales divided by total assets. Indicates firm's efficiency in utilizing assets to generate sales. What does it indicate? Measures adequacy of operations. Generally, it should remain relatively constant over time. Ratio combines the utilization of fixed assets with the management of current assets. Lower ratio combined with a lower than average fixed asset turnover is an indicator of good management of working capital.Calculation = Net sales divided by total assets. Indicates firm's efficiency in utilizing assets to generate sales. What does it indicate? Measures adequacy of operations. Generally, it should remain relatively constant over time. Ratio combines the utilization of fixed assets with the management of current assets. Lower ratio combined with a lower than average fixed asset turnover is an indicator of good management of working capital.

67. 67 Officers Compensation to Sales Officers Compensation Net Sales Small businesses often over pay owners or officers Why? To avoid double taxation on corporate profits and on dividends. Consideration RMA often does not provide comparatives. Total return to corporate ownership must be considered as to corporate performance. In many situations, the compensation to ownership is difficult to quantify. This ratio must be used with care. Small businesses often over pay owners or officers Why? To avoid double taxation on corporate profits and on dividends. Consideration RMA often does not provide comparatives. Total return to corporate ownership must be considered as to corporate performance. In many situations, the compensation to ownership is difficult to quantify. This ratio must be used with care.

68. 68 EXERCISE 4 Calculate the Operating Ratios for Berry

69. 69 Gross Profit Margin Berry Gross Profit = 748.3 = 28.3% Net Sales 2643.1 RMA 18.0 RMA ratio was 18.0%. On comparable sales the Gross Profit would be 475758 Berry was 26.6, 26.7 and 28.3. Why is Berry higher than the industry? Established customer relationships Significant additional services for which customers are willing to pay a higher price for. Are there operating expenses that should be included in COGS? Can this be maintained??? Income statement does not reveal any of these. A creditor would have concern that the GPM cannot be sustained in a highly competitive industry. Can Berry weather a greater competitive market? Could sluggish sales be related to the pricing?RMA ratio was 18.0%. On comparable sales the Gross Profit would be 475758 Berry was 26.6, 26.7 and 28.3. Why is Berry higher than the industry? Established customer relationships Significant additional services for which customers are willing to pay a higher price for. Are there operating expenses that should be included in COGS? Can this be maintained??? Income statement does not reveal any of these. A creditor would have concern that the GPM cannot be sustained in a highly competitive industry. Can Berry weather a greater competitive market? Could sluggish sales be related to the pricing?

70. 70 Operating Profit Margin Berry Operating Profit = 120.6 = 4.6% Net Sales 2653.1 RMA 3.7 RMA median ratio is 3.7 On comparable sales, 97795 Operating Expenses are 377963 Berry had 3.3%, 2.9% & 4.6% Operating Expenses 627700 What does this mean? Coupled with the high gross profit margin, it is clear that the operating expenses of Berry may be out of control. Or expenses should be in COGS Operating expenses at 23.7% is above the industry average of 15.3%. Is management of this firm is floundering? RMA median ratio is 3.7 On comparable sales, 97795 Operating Expenses are 377963 Berry had 3.3%, 2.9% & 4.6% Operating Expenses 627700 What does this mean? Coupled with the high gross profit margin, it is clear that the operating expenses of Berry may be out of control. Or expenses should be in COGS Operating expenses at 23.7% is above the industry average of 15.3%. Is management of this firm is floundering?

71. 71 Profit to Total Assets Berry Profit Before Tax = 61.2= 3.9% Total Assets 1559.7 RMA 4.1 RMA Median is 4.1% Berry ratio ranges from 2.0,1.1 3.9 How is this explained? . Three year average of 2.1% inability of management to utilize the assets to generate an adequate return. Why is the firm remaining in business? RMA Median is 4.1% Berry ratio ranges from 2.0,1.1 3.9 How is this explained? . Three year average of 2.1% inability of management to utilize the assets to generate an adequate return. Why is the firm remaining in business?

72. 72 Profit to Tangible Net Worth Berry Profit Before Tax = 61.2 = 13.2% Tangible Net Worth 435 RMA 17.1 Should owners of a firm expect an adequate return on the investment? There are many ways for the owners to take funds from the business. It is difficult to measure true return on equity. By relating the profit before tax to the equity on the balance sheet, we can compare a firm with similar firms in the industry. Berry earns a return on equity far less than the peer company and less than could be earned if the funds were invested in a government security The return in the early years were 6.6 and 3.0 Is the 13.2 irrational? Is it irrational for a business person to remain in business without a higher return on equity? Should a lender provide funds assuming the business person will accept lower ROE? Should owners of a firm expect an adequate return on the investment? There are many ways for the owners to take funds from the business. It is difficult to measure true return on equity. By relating the profit before tax to the equity on the balance sheet, we can compare a firm with similar firms in the industry. Berry earns a return on equity far less than the peer company and less than could be earned if the funds were invested in a government security The return in the early years were 6.6 and 3.0 Is the 13.2 irrational? Is it irrational for a business person to remain in business without a higher return on equity? Should a lender provide funds assuming the business person will accept lower ROE?

73. 73 Fixed Asset Turnover Net Sales 2643.1 = 12.7 Net Fixed Assets 208.4 RMA 6.0 RMA 6.0 Berry 11.4, 13.8 12.7 Is the plant obsolete? Total cost of fixed assets 685100, Accumulated Depreciation 476100, 69% depreciated. What is the depreciation method?minimal purchases of new assets. Is the plant being maintained adequately? RMA 6.0 Berry 11.4, 13.8 12.7 Is the plant obsolete? Total cost of fixed assets 685100, Accumulated Depreciation 476100, 69% depreciated. What is the depreciation method?minimal purchases of new assets. Is the plant being maintained adequately?

74. 74 Total Asset Turnover Berry Net Sales = 2643.1 = 1.7 Total Assets 1559.7 RMA 1.7 RMA median ratio is 1.7 Berry ratio is the same as the industry What does this indicate? IsBerryI using assets efficiently? With a high FATO, is investment is misallocated. Is the firm is obtaining adequate return from those sales? RMA median ratio is 1.7 Berry ratio is the same as the industry What does this indicate? IsBerryI using assets efficiently? With a high FATO, is investment is misallocated. Is the firm is obtaining adequate return from those sales?

75. 75 Officers Compensation to Sales Berry Officers Comp = Net Sales RMA RMA median Berry does not show any officers salaries. What does this mean? Without information it is difficult to determine any problem It is assumed that the owners take out a living wage. It is barried in the G&A Why? Is this to maintain minimal profits & little taxation? Does the family participate in profit sharing, use of automobiles, etc. Profitability and changes in operating ratios might be improved if excess compensation was added back. We do not have sufficient data to make that adjustment What have the ratios told us? SHAI has a working capital problem, is not generating sufficient cash to pay creditors, has a highly depreciated plant and is not profitable. It would be difficult for a lender to provide funds to SHAIRMA median Berry does not show any officers salaries. What does this mean? Without information it is difficult to determine any problem It is assumed that the owners take out a living wage. It is barried in the G&A Why? Is this to maintain minimal profits & little taxation? Does the family participate in profit sharing, use of automobiles, etc. Profitability and changes in operating ratios might be improved if excess compensation was added back. We do not have sufficient data to make that adjustment What have the ratios told us? SHAI has a working capital problem, is not generating sufficient cash to pay creditors, has a highly depreciated plant and is not profitable. It would be difficult for a lender to provide funds to SHAI

76. 76 Break-Even Analysis Fixed Costs Variable Costs Formula: Fixed (1-Variable/Sales) Contribution to Operating Costs Break-even - Assumes there are two types of costs Expenses which vary with sales, such as COGS or commissions. Fixed costs that must be paid irregardless, such as rent, utilities.. Formula for break-even is: Fixed costs 1 - variable costs/ net sales A corollary to break-even is the degree of operating leverage. The dollars of sales required to generate one dollar of cash. Assumes that the firm will operate similarly in the future. Premise is that additional sales will require additions to the working capital assets. Formula: Net Sales [Gross Profit - (Cash +AR+Inv-AP)(1-Tax Rate)] Break-even - Assumes there are two types of costs Expenses which vary with sales, such as COGS or commissions. Fixed costs that must be paid irregardless, such as rent, utilities.. Formula for break-even is: Fixed costs 1 - variable costs/ net sales A corollary to break-even is the degree of operating leverage. The dollars of sales required to generate one dollar of cash. Assumes that the firm will operate similarly in the future. Premise is that additional sales will require additions to the working capital assets. Formula: Net Sales [Gross Profit - (Cash +AR+Inv-AP)(1-Tax Rate)]

77. 77 Modified Break-Even COGS always variable All other costs are fixed GPM is denominator Slightly higher break-even What is the difficulty of break-even analysis? To decide what is fixed and what is variable If we assume that cost of goods sold is always variable and that all other costs are fixed, we simplify the formula to: Total costs - cost of goods sold Gross profit Margin This approach always provides a slightly higher Break-even since the fixed costs are lower. What is the difficulty of break-even analysis? To decide what is fixed and what is variable If we assume that cost of goods sold is always variable and that all other costs are fixed, we simplify the formula to: Total costs - cost of goods sold Gross profit Margin This approach always provides a slightly higher Break-even since the fixed costs are lower.

78. 78 EXERCISE 5 Calculate the Modified breakeven for Berry This exercise was missing in Los Angeles This exercise was missing in Los Angeles

79. 79 Break-Even Berry Fixed Costs 627.7 Gross Profit Margin .283 Break-Even Sales 2218.0 Break-Even Percent 83.9% RMA .18 Berry break-even point is 83.9% If we use the median gross profit margin of 18%. Then the Break-even sales would be 3487 What does this mean? The high gross Margin gives us a reasonable break even. Fixed costs appear to be high since the company could not break even with the lower gross profit margin There is no ability to withstand any downturn in sales. Or to withstand a decrease in gross margin. Since sales have been relatively flat(less than 2% increase) or the entire period under review, this company is very vulnerable. Berry break-even point is 83.9% If we use the median gross profit margin of 18%. Then the Break-even sales would be 3487 What does this mean? The high gross Margin gives us a reasonable break even. Fixed costs appear to be high since the company could not break even with the lower gross profit margin There is no ability to withstand any downturn in sales. Or to withstand a decrease in gross margin. Since sales have been relatively flat(less than 2% increase) or the entire period under review, this company is very vulnerable.

80. 80 Common Size Analysis Accounts as Percentage Balance Sheet Income Statement Useful for Trends Why use common size analysis? Dollar figures may not reveal as much. Using a common base, more insight can be obtained. Can relate each account on the balance sheet to total assets as a percent. Can relate each account on the income statement to net sales. More clearly identify trends in assets, liabilities and operational expenses. Let’s calculate the common size for SHAI Why use common size analysis? Dollar figures may not reveal as much. Using a common base, more insight can be obtained. Can relate each account on the balance sheet to total assets as a percent. Can relate each account on the income statement to net sales. More clearly identify trends in assets, liabilities and operational expenses. Let’s calculate the common size for SHAI

81. 81 Common Size Analysis Berry Balance Sheet 2002 2003 2004 Current Assets 82 84 82 Fixed Assets 15 13 13 Cur Liabilities 69 69 57 LT Liabilities 13 Equity 31 30 30 Current assets has increased over the years studied. Note that Accounts receivable are nearly 60% of total assets. If A/R are not collectible, N/W could be reduced by about $100,000 N/W is worse than the numbers show. Fixed Assets continue to diminish Older company Older (obsolete) assetsCurrent assets has increased over the years studied. Note that Accounts receivable are nearly 60% of total assets. If A/R are not collectible, N/W could be reduced by about $100,000 N/W is worse than the numbers show. Fixed Assets continue to diminish Older company Older (obsolete) assets

82. 82 Common Size Analysis Berry Income Stmt 1998 1999 2000 COGS 73 73 72 Oper Costs 23 24 24 NP Before Tax 1.2 0.6 2.3 Income statement reflects Improved COGS (and GPM) Failure to control costs. What do we need to know? Investigate major expenses to determine what is out of line. Look closely at family compensation We know that employees are paid at top rates. We need a breakdown of the operating expenses The following general comments can be made Uncollectible accounts Lack of operational and net income Flat Sales Depreciated Plant Inability to generate cash to repay any new loanIncome statement reflects Improved COGS (and GPM) Failure to control costs. What do we need to know? Investigate major expenses to determine what is out of line. Look closely at family compensation We know that employees are paid at top rates. We need a breakdown of the operating expenses The following general comments can be made Uncollectible accounts Lack of operational and net income Flat Sales Depreciated Plant Inability to generate cash to repay any new loan

83. 83 Bankruptcy Prediction Nine Values Current Assets Current Liabilities Retained Earnings Total Assets Total Liabilities Net Worth Net Sales Interest Pre-Tax Earnings 1968 - Professor Edward Altman developed a bankruptcy predictor - - utilized certain variables in a statistically derived combination. Dr. Altman used financial statements for several years of publicly traded manufacturing companies which had declared bankruptcy. He identified common financial relationships that could forewarn of potential bankruptcy two years prior to the bankruptcy. The algorithm has been tested by other researchers on different types of data and is reported to have a 95% accuracy of prediction of bankruptcy two year prior to failure. Variables identified included: Current Assets Current Liabilities Total Assets Total Liabilities Retained Earnings Net Sales Interest Earnings Before Taxes 1968 - Professor Edward Altman developed a bankruptcy predictor - - utilized certain variables in a statistically derived combination. Dr. Altman used financial statements for several years of publicly traded manufacturing companies which had declared bankruptcy. He identified common financial relationships that could forewarn of potential bankruptcy two years prior to the bankruptcy. The algorithm has been tested by other researchers on different types of data and is reported to have a 95% accuracy of prediction of bankruptcy two year prior to failure. Variables identified included: Current Assets Current Liabilities Total Assets Total Liabilities Retained Earnings Net Sales Interest Earnings Before Taxes

84. 84 Five Relationships Liquidity NWC/NS Retention RE/TA Leverage NW/TL Turnover NS/TA Earnings EBIT/TA Variables were combined into five relationships. Each ratio or relationship was given a weight. The value of each relationship was multiplied by the weight The values summed to obtain an overall score for the firm called the Z score Note: Leverage uses NW/TL - reverse of what is commonly used.Variables were combined into five relationships. Each ratio or relationship was given a weight. The value of each relationship was multiplied by the weight The values summed to obtain an overall score for the firm called the Z score Note: Leverage uses NW/TL - reverse of what is commonly used.

85. 85 Bankruptcy Valuation Liquidity 1.2 Retention 1.4 Leverage 0.6 Turnover 1.0 Earnings 3.3 Dr Altman developed weights to be applied to the five qualities. Dr Altman developed weights to be applied to the five qualities.

86. 86 Bankruptcy Interpretation > 3.0 Safe 2.7 - 3.0 Gray Area 1.8 - 2.7 Danger <1.8 Imminent Range of Z-scores were given an interpretation > 3.0 - firm appears to be safe . 2.7 to 3.0 - firm may be safe, but some weaknesses exist 1.8 - 2.7 - firm likely to be bankrupt within two years. Firm has serious weaknesses and requires dramatic action Below 1.8 - firm is very likely headed for bankruptcy. Rarely will a firm recover from a financial condition generating this score. Caution: Industries with different structures may differ Some ratios may be skewedRange of Z-scores were given an interpretation > 3.0 - firm appears to be safe . 2.7 to 3.0 - firm may be safe, but some weaknesses exist 1.8 - 2.7 - firm likely to be bankrupt within two years. Firm has serious weaknesses and requires dramatic action Below 1.8 - firm is very likely headed for bankruptcy. Rarely will a firm recover from a financial condition generating this score. Caution: Industries with different structures may differ Some ratios may be skewed

87. 87 Bankruptcy Considerations Firms with Low Assets to Sales Misleading Result Constrain NS/TA to 1.0 Cautions Firms with low assets to sales, the ratio of NS/TA may distort the result. Note that this ratio gets a weight of one. In some instances, this relationship can be more than 50% of the Z Score. In that event, an adjustment is to constrain this ratio to no more than 1.0 For example: Calculate the modified Z Score for SHAICautions Firms with low assets to sales, the ratio of NS/TA may distort the result. Note that this ratio gets a weight of one. In some instances, this relationship can be more than 50% of the Z Score. In that event, an adjustment is to constrain this ratio to no more than 1.0 For example: Calculate the modified Z Score for SHAI

88. 88 Bankruptcy Berry NWC/NS 381.9/2432.3 = 0.16 RE/TA 459.0/1559.7 = 0.29 NW/TL 463.1/1096.6 =0.42 NS/TA 2643.1/1559.7 = 1.69 EBIT/TA 120.6/1559.7 = 0.08 . However, after we make adjustments to the financial statement to remove certain assets which are probably valueless, we can affect the Z- score. Consider this Adjustments: Remove from the Current Assets, $100,000 in uncollectible accounts receivable. Now, recalculate the Z-score . However, after we make adjustments to the financial statement to remove certain assets which are probably valueless, we can affect the Z- score. Consider this Adjustments: Remove from the Current Assets, $100,000 in uncollectible accounts receivable. Now, recalculate the Z-score

89. 89 BANKRUPTCY BERRY LIQUIDITY 1.2*.16 = 0.19 RETENTION 1.4*.29 = 0.41 LEVERAGE 0.6*.42 = 0.25 TURNOVER 1.0*1.69= 1.69 EARNINGS 3.3*.08 = 0.26 SCORE 2.80 Applying the bankruptcy prediction model we find that the company is marginal since the score of 2.80 is less than 3 which is safe If we constrain the turnover to the 1, we get a value of only 2.11 which is in the danger area. Given the high gross margin which cannot probably be maintained, this company is subject to bankruptcy.Applying the bankruptcy prediction model we find that the company is marginal since the score of 2.80 is less than 3 which is safe If we constrain the turnover to the 1, we get a value of only 2.11 which is in the danger area. Given the high gross margin which cannot probably be maintained, this company is subject to bankruptcy.

90. 90 Objective Three Analysis of Working Capital Function of Working Capital Cash Cycle Analysis Funding Requirements In objective three, we want to examine the flows of cash and the adequacy of working capital. We will discuss the cash cycle in the business and its calculation and use The cash cycle can be a tool in determining the need for financing.In objective three, we want to examine the flows of cash and the adequacy of working capital. We will discuss the cash cycle in the business and its calculation and use The cash cycle can be a tool in determining the need for financing.

91. 91 Function of Working Capital Meet Operational Needs Pay Short-Term Creditors Pay Labor and Overhead Acquire Additional Inventory Support Accounts Receivable Purpose of Working Capital: (1) meet its operational needs; (2) pay short-term creditors, labor and overhead; (3) to acquire additional inventory; and (4) to support increasing accounts receivables. Purpose of Working Capital: (1) meet its operational needs; (2) pay short-term creditors, labor and overhead; (3) to acquire additional inventory; and (4) to support increasing accounts receivables.

92. 92 Liquidity Ratios Current Ratio Quick Ratio Accounts Receivable Turnover Inventory Turnover Accounts Payable Turnover Sales to Working Capital Review of earlier discussion Current Ratio - overall barometer of working capital adequacy, used in comparison with prior years & other firms Quick Ratio - More stringent measure of liquidity and indicator of the company's ability to generate cash quickly. Accounts Receivable Turnover - Indicator of the extent of investment in receivables and the timing of the receipt of proceeds. Inventory Turnover - Indicator of the ability of the firm to convert materials into saleable goods. Accounts Payable Turnover - Indicates the capability of the firm to meet suppliers requirements for payment. Review of earlier discussion Current Ratio - overall barometer of working capital adequacy, used in comparison with prior years & other firms Quick Ratio - More stringent measure of liquidity and indicator of the company's ability to generate cash quickly. Accounts Receivable Turnover - Indicator of the extent of investment in receivables and the timing of the receipt of proceeds. Inventory Turnover - Indicator of the ability of the firm to convert materials into saleable goods. Accounts Payable Turnover - Indicates the capability of the firm to meet suppliers requirements for payment.

93. 93 Operating Capital Time from Cash to Cash Days in Working Capital Sales Required to Finance A firm needs cash to operate. The level of this need is a critical element in analysis. The working capital assets and trade credit is related to average daily sales. On flip chart, show cash cycleA firm needs cash to operate. The level of this need is a critical element in analysis. The working capital assets and trade credit is related to average daily sales. On flip chart, show cash cycle

94. 94 Operating Cash Cycle Use Calculated Turnover Days Collection Period + Days of Inventory = Operating Cycle - Days of Accounts Payable = Cash Cycle Draw on flip chart or chalkboard: Inventory Period + Collection Period = Operating Cycle Operating Cycle - Accounts Payable Period = Cash Cycle Draw on flip chart or chalkboard: Inventory Period + Collection Period = Operating Cycle Operating Cycle - Accounts Payable Period = Cash Cycle

95. 95 Operating and Cash Cycle Calculate for Each Year Berry Industries Interpret the Results Divide attendees into two groups Group 1: SHAI and RMA Group 2: McAllen and RMA Divide attendees into two groups Group 1: SHAI and RMA Group 2: McAllen and RMA

96. 96 CASH CYCLE BERRY ALL YEARS 2002 2003 2004 Collection Pd 29 31 27 Inventory Days 161 159 173 Oper Cycle 190 190 190 Payable Days 29 31 36 Cash Cycle 161 159 154

97. 97 Operating and Cash Cycle Berry Use Calculated Turnover Days 2004 Berry RMA Collection Period 27 days 28 Days of Inventory 173 Days 96 Operating Cycle 200 Days 124 Days of Accts Pay 36 Days 23 Cash Cycle 164 Days 101 Berry COLLECTION Period is at the median. INV DAYS At 173 days, is 80% greater than the median and is below the lower quartile. The company has too much inventory. OP CYCLE at 200 Days is lower than the lower quartile at 180 days AP DAYS At 36 days is just above the lower quaratile CASH CYCLE At 164 days is 62% greater than the median and 17% lower thaan the lower quarrtile. The major discrepancy in the analysis is the inventory days.. Why is the inventory so high? The product is perishable, can the inventory be sold? The company has leaned on trade creditors for funds to operate. What would be the primary source of trade credit? ProducersBerry COLLECTION Period is at the median. INV DAYS At 173 days, is 80% greater than the median and is below the lower quartile. The company has too much inventory. OP CYCLE at 200 Days is lower than the lower quartile at 180 days AP DAYS At 36 days is just above the lower quaratile CASH CYCLE At 164 days is 62% greater than the median and 17% lower thaan the lower quarrtile. The major discrepancy in the analysis is the inventory days.. Why is the inventory so high? The product is perishable, can the inventory be sold? The company has leaned on trade creditors for funds to operate. What would be the primary source of trade credit? Producers

98. 98 Cash Requirements Net Sales Last Fiscal Year Minus: Net Profit Minus: Depreciation Equals: Net Cash Expend Divided by: 365 Equals: Net Daily Cash Expend Times: Cash Cycle in Days Equals: Approx Cash Needs

99. 99 Cash Requirements Berry 2004 RMA . Net Sales 2643 2643 Less Net Profit 47 48 Less Depreciation 26 69 Cash Expenditures 2570 2526 Aver Daily Expend 7041 6920 Times Cash Cycle 164 101 Approx Cash Req $ 1154.7 $699.0 Lets look at Berry Using the same level of sales, the RMA calculation indicates an average daily expenditure of $6,920. Multiplied by the RMA Cash Cycle of 101, the approximate needs for funds is $699,000. These funds can come from operations or from borrowing. In contrast, the daily average expenditure of Berry of $7041 is close to the RMA level. The approximate cash requirement is $1,154.7 or 65% higher than the peer company. This is because of the high Cash Cycle caused by excessive inventory If SHAI meets the goal of increasing sales by 7%, and makes the profit of $444.0 it needs no more funds. If the profit were at the percentage for RMA 1%, then profits would be 62.0 and the need for funds would be an additional $35,000. Where is this coming from?Lets look at Berry Using the same level of sales, the RMA calculation indicates an average daily expenditure of $6,920. Multiplied by the RMA Cash Cycle of 101, the approximate needs for funds is $699,000. These funds can come from operations or from borrowing. In contrast, the daily average expenditure of Berry of $7041 is close to the RMA level. The approximate cash requirement is $1,154.7 or 65% higher than the peer company. This is because of the high Cash Cycle caused by excessive inventory If SHAI meets the goal of increasing sales by 7%, and makes the profit of $444.0 it needs no more funds. If the profit were at the percentage for RMA 1%, then profits would be 62.0 and the need for funds would be an additional $35,000. Where is this coming from?

100. 100 Group Exercise Precision Interpret the Ratios Calculate Breakeven Calculate Bankruptcy Predictor Calculate Operating and Cash Cycle Handout the three sheets of Precision. Note that the NAICS category is critical in evaluating how the firm compares with the industry This handout is based on the information in a STLP filing The original NAICS was 237310, Highway Street and Bridge Construction; the other NAICS is 236220, Commercial and Institutional Building Construction Use the fiscal year data, the interim is for 6 months Current: Latest year slightly greater than the median Quick: no comparison; At 1.7 fine Receivable Turnover 7.2 vs RMA 8.4 Days 51 vs. 43 Inventory not appropriate Payables 13.7 vs 10.1 Days 29 vs 36 Sales/WC 9 vs. 13.7 Times Interest Earned 17 vs. 4.4 Debt Coverage 8.7 vs. 2.0 FA/TNW 0.8 vs. 0.3 Close to lower quartile of 0.9 Debt/TNW 1.0 vs. 1.8 Leverage is ok PBT/TNW 73 vs. 13 Unusually high PBT/TA 37.2 vs. 3.7Unusally High, great variation over the three years. Why? GPM 30.3 vs. 18.5. Are some costs not included in COGS Operating Profit Margin 15.7 vs. 1.7 Great variation over the years. Net Profit Margin 14.8 vs. (0.8) Great variation NS/FA 6.3 NS/TA 2.5 vs. Common Size Analysis Note the higher COGS for RMA and Higher Expense Handout the three sheets of Precision. Note that the NAICS category is critical in evaluating how the firm compares with the industry This handout is based on the information in a STLP filing The original NAICS was 237310, Highway Street and Bridge Construction; the other NAICS is 236220, Commercial and Institutional Building Construction Use the fiscal year data, the interim is for 6 months Current: Latest year slightly greater than the median Quick: no comparison; At 1.7 fine Receivable Turnover 7.2 vs RMA 8.4 Days 51 vs. 43 Inventory not appropriate Payables 13.7 vs 10.1 Days 29 vs 36 Sales/WC 9 vs. 13.7 Times Interest Earned 17 vs. 4.4 Debt Coverage 8.7 vs. 2.0 FA/TNW 0.8 vs. 0.3 Close to lower quartile of 0.9 Debt/TNW 1.0 vs. 1.8 Leverage is ok PBT/TNW 73 vs. 13 Unusually high PBT/TA 37.2 vs. 3.7Unusally High, great variation over the three years. Why? GPM 30.3 vs. 18.5. Are some costs not included in COGS Operating Profit Margin 15.7 vs. 1.7 Great variation over the years. Net Profit Margin 14.8 vs. (0.8) Great variation NS/FA 6.3 NS/TA 2.5 vs. Common Size Analysis Note the higher COGS for RMA and Higher Expense

101. 101 PRECISION BREAKEVEN FIXED EXPENSES 545.3 GROSS PROFIT MARGIN .303 BREAKEVEN 1799.7 PERCENT OF NET SALES 51% Fixed expenses are operating costs plus interest expense.Fixed expenses are operating costs plus interest expense.

102. 102 PRECISION BANKRUPTCY LIQUIDITY NWC/NS .11 X 1.2 = .13 RETENTION RE/TA .44 X 1.4 = .62 LEVERAGE NW/TL 1.0 X 0.6 = .61 TURNOVER NS/TA 2.5 X 1.0=1.00 EARNINGS EBIT/TA .39 X .3=1.30 TOTAL 3.66 Turnover constrained to 1.Turnover constrained to 1.

103. 103 PRECISION OPERATING AND CASH CYCLE 2000 2001 2002 COLLECTION PD 48 114 51 NO INVENTORY OPERATING CYCLE 48 114 51 PAYABLE DAYS 39 72 14 CASH CYCLE 9 42 37 The numbers and the calculations are all over the map. We do not have a good industry comparable. It is difficult to interpret. The next slide will indicate the amount of funding required for each year.The numbers and the calculations are all over the map. We do not have a good industry comparable. It is difficult to interpret. The next slide will indicate the amount of funding required for each year.

104. 104 PRECISION CASH REQUIREMENTS 2000 2001 2002 NET SALES 890 1138 3513 NET INCOME 123 50 518 DEPREC 6 18 91 CASH EXP 761 1070 2904 DAILY EXP 2095 2932 7956 CASH CYCLE 9 42 37 CASH REQ 18765 123144 294372 This slide indicates the dollars that must be obtained either from internal sources or by borrowing in each of the years to support the business. In 2000, a total of $18,765 was the financing for the cash cycle; in 2001, the amount was $123,144 and in 2002 $294,372. The line of credit under the STLP is 150,000This slide indicates the dollars that must be obtained either from internal sources or by borrowing in each of the years to support the business. In 2000, a total of $18,765 was the financing for the cash cycle; in 2001, the amount was $123,144 and in 2002 $294,372. The line of credit under the STLP is 150,000

105. 105 Objective Four Analysis of Cash Flow Repayment Ability Repayment of a loan must come from cash generated by the operations of the business. Therefore the analyst must clearly understand the ability of the firm to generate sufficient cash to pay its bills and to meet the amortization requirements of the new loan.Repayment of a loan must come from cash generated by the operations of the business. Therefore the analyst must clearly understand the ability of the firm to generate sufficient cash to pay its bills and to meet the amortization requirements of the new loan.

106. 106 Basic Cash Flow Net Income + Depreciation and Amortization + Deferred Income Tax + or – Change in Working Capital = Operating Cash Flow – Capital Expenditures = Discretionary Cash Flow

107. 107 Basic Cash Flow Cont’d Discretionary Cash Flow + Other Cash Income – Dividends = Cash Flow Before Financing + or – Change in Indebtedness Change in Equity = Change in Cash

108. 108 Traditional Cash Flow Lender Approach Uses Income Statement Cash Flows Adjusts for Other Expenses Ignores Balance Sheet Changes

109. 109 Traditional Cash Flow Net Income + Depreciation + Other Non-Cash Expenses + Interest Expense + Rent (If Purchase of RE) Less AFO Existing Debt Less AFO of New Debt Illustrated in greater detail - Net Income + Non-cash expenditures. + Interest expense (to compare to total of required loan payments). + Rent if the proposed loan replaces rent + Any other expenses which no longer occur. Adding back interest can be dangerous. If the firm has a LOC, the interest on that line has nothing to do with ability to repay a new loan. Interest expense must be adjusted for the interest related to LOC.Illustrated in greater detail - Net Income + Non-cash expenditures. + Interest expense (to compare to total of required loan payments). + Rent if the proposed loan replaces rent + Any other expenses which no longer occur. Adding back interest can be dangerous. If the firm has a LOC, the interest on that line has nothing to do with ability to repay a new loan. Interest expense must be adjusted for the interest related to LOC.

110. 110 Statement of Cash Flow Traces Flow of Cash Over Period Considers Changes in Balance Sheet Truer Picture of Cash Flows Statement of Cash Flow or UCA Traces the flow of all cash over the period. Includes Income Statement flows Also reflects the changes in the Balance Sheet accounts. For example A firm may use cash to support growth in A/R or Inventory for growth. These funds are tied up in the business and not available for loan payment. The UCA Statement of Cash Flow Provides a truer picture of the cash flows. Flows may be significantly different from the traditional approachStatement of Cash Flow or UCA Traces the flow of all cash over the period. Includes Income Statement flows Also reflects the changes in the Balance Sheet accounts. For example A firm may use cash to support growth in A/R or Inventory for growth. These funds are tied up in the business and not available for loan payment. The UCA Statement of Cash Flow Provides a truer picture of the cash flows. Flows may be significantly different from the traditional approach

111. 111 Statement of Cash Flow Operating Activity Cash generated by business activity Investing Activity Acquisition and disposal of fixed assets Financing Activity Borrowing or payment to creditors Withdrawals or injections of owner capital Balance Sheet and Income Statement are used to identify: Cash from Operations Cash Flow from Investment activity Cash Flow from financing Financing Cash Flows are payments to and receipt of funds from outside creditors and the payment of dividends or the injection of funds to and from owners. Balance Sheet and Income Statement are used to identify: Cash from Operations Cash Flow from Investment activity Cash Flow from financing Financing Cash Flows are payments to and receipt of funds from outside creditors and the payment of dividends or the injection of funds to and from owners.

112. 112 UCA Cash Flow Modifies Cash Flow from OPNS Deducts Dividends Assumes dividends is normal cost Deducts Current Portion of LT Debt Existing obligation must be paid UCA Cash Flow was developed by AICPA as standard part of audited financial statements. It builds upon the Income statement Takes into account changes in the Balance Sheet Accounts for Dividends Paid on the assumption that this is a normal payment to owners for the risk assumed. Accounts for all cash transactions. Any surplus funds are then compared to the loan payment on the new loan.UCA Cash Flow was developed by AICPA as standard part of audited financial statements. It builds upon the Income statement Takes into account changes in the Balance Sheet Accounts for Dividends Paid on the assumption that this is a normal payment to owners for the risk assumed. Accounts for all cash transactions. Any surplus funds are then compared to the loan payment on the new loan.

113. 113 Traditional Cash Flow Berry 2004 Net Income + 47.3 Depreciation + 26.4 Interest Expense + 66.4 Total 140.1 Less AFO 39.0 Net 101.0 Less AFO of New Debt 70.1 Cushion 59.9 Loan Coverage 1.8 Illustrate by comparing cash flow under both methods. First, calculate cash flow by the traditional “Rule of Thumb”. Remember - The company does have a LOC. Assuming the short term notes payable are in the line of credit, about 38,000 of the interest expense is not available to pay a loan. Any new loan would have only 63.0 cash available to meet the AFO. . Under the traditional approach, the firm generates sufficient cash flow to repay the loan. There is a comfortable coverage of 1.8.Illustrate by comparing cash flow under both methods. First, calculate cash flow by the traditional “Rule of Thumb”. Remember - The company does have a LOC. Assuming the short term notes payable are in the line of credit, about 38,000 of the interest expense is not available to pay a loan. Any new loan would have only 63.0 cash available to meet the AFO. . Under the traditional approach, the firm generates sufficient cash flow to repay the loan. There is a comfortable coverage of 1.8.

114. 114 Cash Flow From Operations Operating Activity 2003 2004 Net Income 7.2 47.3 Depreciation 22.2 26.4 Amortization Change in A/R (29.7) 11.4 Change in Inventory (51.9) (121.2) Change in OCA (65.9) 5.9 Change in AP 20.2 34.3 Change in Accruals 6.9 12.6 Operating Cash Flow (91.2) 16.7 Illustrate on sheet board Statement of Operating Cash Flow How does this compare to Cash Flow under the Traditional Method?Illustrate on sheet board Statement of Operating Cash Flow How does this compare to Cash Flow under the Traditional Method?

115. 115 Adjustments to Operating Cash Flow 2004 Operating Cash Flow 16.7 - Capital Expenditures 59.8 Discretionary CF (43.1)+ Other Income 7.0 Change in Debt (102.8) Change in Equity

116. 116 UCA Cash Flow for Berry 1999 2000 Cash Flow from Opns (91.2) 16.7 Deduct Dividends 0 0 Deduct CP LTD (45.4) (47.4) CF after Debt Retire (136.6) (30.7) How does this cash flow compare to traditional method? Do you think that it is more reliable? This is a more stringent test of the ability of the firm to repay new indebtedness from cash flow from the operations of the business.How does this cash flow compare to traditional method? Do you think that it is more reliable? This is a more stringent test of the ability of the firm to repay new indebtedness from cash flow from the operations of the business.

117. 117 EXERCISE PRECISION Calculate Cash Flow for 2002and 2003 Traditional Method Statement of Cash Flows UCA Cash Flow Compare Results

118. 118 Precision Traditional Cash Flow 2001 2002 Net Income 49.8 518.3 Depreciation 17.9 91.3 Interest 4.2 32.4 Total 71.9 642.0 Less Current AFO 14.3 43.2 Net 55.6 598.8 Note: It is not clear from the application just what is the annual fixed obligation on existing indebtedness. The amounts in the slide assumes a 10% interest rate on all long term indebtedness with the addition of the current portion of long term debt shown on the balance sheet. The monthly payments reflected on the back of the form 4 calculate to a larger payment requirement. Note: The owners are withdrawing nearly all the income generated during the year. Based on this analysis, is the cash flow sufficient to amortize the additional loan? What could the loan officer do? He could restrict owners withdrawals in the loan authorization. What happens if the owner still takes out the funds? Does the owner require the funds to support living expenses?Note: It is not clear from the application just what is the annual fixed obligation on existing indebtedness. The amounts in the slide assumes a 10% interest rate on all long term indebtedness with the addition of the current portion of long term debt shown on the balance sheet. The monthly payments reflected on the back of the form 4 calculate to a larger payment requirement. Note: The owners are withdrawing nearly all the income generated during the year. Based on this analysis, is the cash flow sufficient to amortize the additional loan? What could the loan officer do? He could restrict owners withdrawals in the loan authorization. What happens if the owner still takes out the funds? Does the owner require the funds to support living expenses?

119. 119 Operational Cash Flow Precision Operating Activity 2001 2002 Net Income 49.8 518.3 Depreciation 17.9 91.3 Change in A/R (249.8) (123.3) Change in Excess Cost 23.4 3.9 Change in OCA (4.4) (62.0) Change in AP 100.1 7.4 Change in Accruals 24.0 26.8 Cash Flow from OPNS (39.7) 462.4 Operational Cash Flow considers management’s decisions in managing operating assets. In this case the company had a modest cash flow from operations in 19x8 and a negative cash flow from operations in 19x9.Operational Cash Flow considers management’s decisions in managing operating assets. In this case the company had a modest cash flow from operations in 19x8 and a negative cash flow from operations in 19x9.

120. 120 Precision UCA Cash Flow 2001 2002 Operating (39.7) 462.4 Stockholder Loan (45.2) Total (84.9 ) 462.4 Debt Amort (6.8) (87.1) Total (91.7) 375.3 Under UCA, the dividends are subtracted from Operational Cash Flow on the premise that dividends is a cost of financing that must be recognized. From the remainder, the current portion of indebtedness that had to be paid in the year is deducted to obtain the net cash flow after debt retirement. In this example, in 1998 the firm, paid dividends and had no debt retirement and had a nominal cash available. In 19x9, the result is a deficit of ($81.9).Under UCA, the dividends are subtracted from Operational Cash Flow on the premise that dividends is a cost of financing that must be recognized. From the remainder, the current portion of indebtedness that had to be paid in the year is deducted to obtain the net cash flow after debt retirement. In this example, in 1998 the firm, paid dividends and had no debt retirement and had a nominal cash available. In 19x9, the result is a deficit of ($81.9).

121. 121 Objective Five Collateral Identify Value Secure Loan officer has three tasks related to collateral: Properly Identify all assets to be pledged Must be suitably identified. Serial numbers obtained Legal description of the plat is necessary. Value - The collateral has two values: Market Value & Liquidation Value Adequacy of collateral depends on liquidation value. Secure proper filing of liens. (Most common reason for repairs by SBA) If the loan defaults, the liens will be a record of access to the assets for disposal Loan officer has three tasks related to collateral: Properly Identify all assets to be pledged Must be suitably identified. Serial numbers obtained Legal description of the plat is necessary. Value - The collateral has two values: Market Value & Liquidation Value Adequacy of collateral depends on liquidation value. Secure proper filing of liens. (Most common reason for repairs by SBA) If the loan defaults, the liens will be a record of access to the assets for disposal

122. 122 Types of Collateral Real Estate Other Fixed Assets Working Capital Assets Outside Assets Guarantees SBA has taken just about everything. If you review the appendix to the Authorization, you will note the varieties of collateral and the requirements for information. Cautions: The sterile “stud” Building on wrong lotSBA has taken just about everything. If you review the appendix to the Authorization, you will note the varieties of collateral and the requirements for information. Cautions: The sterile “stud” Building on wrong lot

123. 123 Depreciation Cost Salvage Value Useful Life Method of Allocation Fixed assets depreciate. Loan officer should understand the impact of depreciation. Value of the asset may not actually depreciate. Depreciation is meant to set aside funds to replace asset. Method of allocation (sl, syd, dd bal) impacts the amount of depreciation expense taken in a particular yearFixed assets depreciate. Loan officer should understand the impact of depreciation. Value of the asset may not actually depreciate. Depreciation is meant to set aside funds to replace asset. Method of allocation (sl, syd, dd bal) impacts the amount of depreciation expense taken in a particular year

124. 124 Fixed Asset Ages Average Useful Life GFA/Depreciation Expense Average Remaining Life NFA/Depreciation Expense Average Age Accumulated Depreciation/Depreciation Expense Various approaches to develop the useful life can be used. It can be skewed by heavy investment in real property Formulas usually assume straight line depreciation. The most important figure is the average remaining life. If the loan is for 10 years and the firm must start replacement within 5 years, the loan officer must consider where the financing for the new assets will come fromVarious approaches to develop the useful life can be used. It can be skewed by heavy investment in real property Formulas usually assume straight line depreciation. The most important figure is the average remaining life. If the loan is for 10 years and the firm must start replacement within 5 years, the loan officer must consider where the financing for the new assets will come from

125. 125 Collateral Valuation Liquidation Value Lender Selects Percentage “Collateral Value” Collateral Value is the liquidation value Lender should reduce market value to account for: Holding Period (interest) Cost of maintenance Tax & insurance General maintenance Damage & repair Sales commissions Discount to sell Etc.Collateral Value is the liquidation value Lender should reduce market value to account for: Holding Period (interest) Cost of maintenance Tax & insurance General maintenance Damage & repair Sales commissions Discount to sell Etc.

126. 126 Collateral Considerations Pledge of Assets Acquired If Loan Not Fully Secured Other business assets Assets of principals If Not Fully Secured Other credit factors to offset SBA has certain requirements for collateral: Secure all assets acquired with the loan If not well secured, other available assets must be pledged. If business assets do not fully secure the loan, assets of the principals that can be pledged. If loan is still not fully secured, the loan officer must document why the loan can still be made. Historical earnings Experienced management Favorable economic situation. This must be documented in analysis. SBA has certain requirements for collateral: Secure all assets acquired with the loan If not well secured, other available assets must be pledged. If business assets do not fully secure the loan, assets of the principals that can be pledged. If loan is still not fully secured, the loan officer must document why the loan can still be made. Historical earnings Experienced management Favorable economic situation. This must be documented in analysis.

127. 127 Personal Residences Taken as collateral when: lender requires it, OR other collateral is weak and equity equals 25% of market value. When owner-occupied residence taken as collateral, make no representation of potential release or limiting the possibility of foreclosure in the event of default. Should not “automatically” take personal residence, if the loan is fully secured with business assets. P 91 - owner occupied residences may always be required as collateral where the applicant operates out of the residence or other buildings located on same parcel of land Some states (Texas) prohibit pledge of home for business loan. P 90-91 When owner-occupied residence taken as collateral, make no representation of potential release or limiting the possibility of foreclosure in the event of default. Should not “automatically” take personal residence, if the loan is fully secured with business assets. P 91 - owner occupied residences may always be required as collateral where the applicant operates out of the residence or other buildings located on same parcel of land Some states (Texas) prohibit pledge of home for business loan. P 90-91

128. 128 Liquidation Values Commercial Real Estate 75% Residential Real Estate 80% Unimproved Land 50% Machinery/Equipment 50% Furniture/Fixtures 10% AR/Inventory 20% Leasehold Improvements 5% Liquidation values as established by SBA Not in SOP In Fresno Servicing Manual District Offices may vary If the lender uses a different value (particularly if a higher value is used) the reason must be documented in the file.Liquidation values as established by SBA Not in SOP In Fresno Servicing Manual District Offices may vary If the lender uses a different value (particularly if a higher value is used) the reason must be documented in the file.

129. 129 Net Realizable Value at Default Liquidation Value, Less: Senior Liens Taxes Sales Costs Care and Preservation Why should there be a discount? At default or liquidation: Lender must determine the liquidation value Subtract any prior liens and taxes Estimated costs of the sale Estimated costs of care and preservation = Net realizable value at default Why should there be a discount? At default or liquidation: Lender must determine the liquidation value Subtract any prior liens and taxes Estimated costs of the sale Estimated costs of care and preservation = Net realizable value at default

130. 130 Berry Collateral Type Value % Net Accts Rec 254.3 0 ( Pledged to Revolving Line) Inventory NONE 0 Real Estate NONE 0 Equipment 554.9 50 277.5 Collateral Value Loan/Value SBA requires that all available assets be pledged up to fully securing the loan. When assets available have a value that does not fully secure the loan, there must be strong other factors in the evaluation. What other factors would offset the lack of collateral in this case?SBA requires that all available assets be pledged up to fully securing the loan. When assets available have a value that does not fully secure the loan, there must be strong other factors in the evaluation. What other factors would offset the lack of collateral in this case?

131. 131 Objective Six Adequacy of Equity

132. 132 Equity and Creditor Risk Equity is Cushion Support Alternate Finance Owner Tenacity No Need for Profits Improves Collateral Cushion to protect the interests of the lender. The lower the D/W ratio, the more resiliency to withstand periods of operating losses. A firm with little equity is vulnerable to expensive mistakes or external adversity. The lower the equity, the more difficult it is to obtain alternate financing. If business fails, the owners suffer a financial loss. Tenacity is important when the going is tough; the lender is best served by a borrower who will stay the course. At stake equity provides incentive for owners to make a good effort for success. The greater the equity the less the temptation to walk away in distress. A company with zero debt requires minimal profits. Companies with large amounts of debt must perform very well in order to survive. Cash flow demands for debt service require high operating proficiency. The greater the equity, the more cushion for the lender. Financing 50% of the assets with 100% of the assets securing the loan, is significantly better than a 75% - 25% ratio. The lender is protected by the equity if the loan defaults.Cushion to protect the interests of the lender. The lower the D/W ratio, the more resiliency to withstand periods of operating losses. A firm with little equity is vulnerable to expensive mistakes or external adversity. The lower the equity, the more difficult it is to obtain alternate financing. If business fails, the owners suffer a financial loss. Tenacity is important when the going is tough; the lender is best served by a borrower who will stay the course. At stake equity provides incentive for owners to make a good effort for success. The greater the equity the less the temptation to walk away in distress. A company with zero debt requires minimal profits. Companies with large amounts of debt must perform very well in order to survive. Cash flow demands for debt service require high operating proficiency. The greater the equity, the more cushion for the lender. Financing 50% of the assets with 100% of the assets securing the loan, is significantly better than a 75% - 25% ratio. The lender is protected by the equity if the loan defaults.

133. 133 Guidelines for Equity Needs New Business ^ More Other Credit Factors Type of Business Experience Management vs. Equity New business require more equity. Start up expenses and initial operating losses erode the equity. Earnings can only be estimated and is more uncertain. Strong consistent earnings, well qualified management, history of successful operations, and strong collateral may offset weakness in equity. The type of business impacts the need for equity. Industry norms are useful in determining the level of equity ;needed. SBA maintains a data base by four digit SIC Code which reflects the loan experience over the past 10 years. (Also by franchise) These can be accessed by the lender through the District Office. In a consideration between the relative merits of equity and management, management strengths or weaknesses should point to the appropriate loan decision. New business require more equity. Start up expenses and initial operating losses erode the equity. Earnings can only be estimated and is more uncertain. Strong consistent earnings, well qualified management, history of successful operations, and strong collateral may offset weakness in equity. The type of business impacts the need for equity. Industry norms are useful in determining the level of equity ;needed. SBA maintains a data base by four digit SIC Code which reflects the loan experience over the past 10 years. (Also by franchise) These can be accessed by the lender through the District Office. In a consideration between the relative merits of equity and management, management strengths or weaknesses should point to the appropriate loan decision.

134. 134 Equity Adjustments Overvalued Assets Undervalued Assets Off Balance Sheet Assets and Liabilities As previously discussed: Balance sheet may require certain adjustments This may include undervalued assets. Adjusting for these assets require an independent appraisal. Some businesses have obligations that do not appear on the balance sheet such as leases, contractual obligations and contingencies. Adjustment to reflect the value of the asset and the corresponding liability under the lease can significantly affect the current ratio and the debt/worth ratio.As previously discussed: Balance sheet may require certain adjustments This may include undervalued assets. Adjusting for these assets require an independent appraisal. Some businesses have obligations that do not appear on the balance sheet such as leases, contractual obligations and contingencies. Adjustment to reflect the value of the asset and the corresponding liability under the lease can significantly affect the current ratio and the debt/worth ratio.

135. 135 Family Clothing Store Co A Co B CA 232.8 232.8 FA 184.3 8.1 TA 417.1 240.9 CL 140.2 123.0 LTL 159.0 0.0 NW 117.9 117.9 D/W 2.5 1.0 Let’s compare two similar companies Which company has the better D/W? Why? Company A Larger fixed assets and long term debt. Company A purchased its business premises with a loan requiring payment of $2500 per month. Company B Leases its premises with a lease payment of $2500 per month. If the lease is capitalized on B balance sheet, the companies are nearly identical Let’s compare two similar companies Which company has the better D/W? Why? Company A Larger fixed assets and long term debt. Company A purchased its business premises with a loan requiring payment of $2500 per month. Company B Leases its premises with a lease payment of $2500 per month. If the lease is capitalized on B balance sheet, the companies are nearly identical

136. 136 Different Industries SIC 1442 2642 CA 114.6 198.3 FA 169.8 91.8 TA 284.4 290.1 CL 80.4 150.3 LTL 103.0 67.2 NW 101.0 72.6 D/W 1.8 3.0 In this example Two different industries SIC code 1441 is Sand and Gravel; SIC Code 2642 is Manufacturer of Envelopes. The RMA median D/W for 1442 is 0.7 The RMA median D/W for 2642 is 3.3 The first company is significantly below the median The second company is significantly above the median Debt/Worth ratios peculiar to industriesIn this example Two different industries SIC code 1441 is Sand and Gravel; SIC Code 2642 is Manufacturer of Envelopes. The RMA median D/W for 1442 is 0.7 The RMA median D/W for 2642 is 3.3 The first company is significantly below the median The second company is significantly above the median Debt/Worth ratios peculiar to industries

137. 137 Precision Equity Net Worth 308.1 Debt/Worth Before 2.3 Debt/Worth After LOC 3.4 SBA utilizes the pro-forma balance sheet to reflect a truer picture of the strength of the business. SBA expects the lender to calculate the debt to tangible net worth on an actual basis and on a pro-forma basis Is the debt to worth ratio acceptable? Not until we understand Industry standards Historical trendsSBA utilizes the pro-forma balance sheet to reflect a truer picture of the strength of the business. SBA expects the lender to calculate the debt to tangible net worth on an actual basis and on a pro-forma basis Is the debt to worth ratio acceptable? Not until we understand Industry standards Historical trends

138. 138 Objective Seven Debt Refinancing

139. 139 Reasonable Terms Debt to be refinanced must be on unreasonable terms for current needs of the business Reasonable at inception may or may not still be reasonable for current needs of business Page 54 Reasonableness = existing cash flow is adequate to meet obligations. Analysis consist of: * test for unreasonableness * capability of business to meet existing terms Page 54 The reasonableness test is based on the borrower’s PRESENT SITUATION, not their condition at the time of the original financing. Page 54 Reasonableness = existing cash flow is adequate to meet obligations. Analysis consist of: * test for unreasonableness * capability of business to meet existing terms Page 54 The reasonableness test is based on the borrower’s PRESENT SITUATION, not their condition at the time of the original financing.

140. 140 Loan Officer Report Description of Request Eligibility Availability of Funds Tax Returns Analysis of Credit Collateral Summary The loan officer should report all the information that will be expected to be found by the examiners looking at loan files.The loan officer should report all the information that will be expected to be found by the examiners looking at loan files.

141. 141 Analysis of Credit Financial Statements Balance Sheet Income Statement Ratios Repayment Equity Quality of the financial statements used for the analysis should be commented on. Analysis of the balance sheet, trends, needed adjustments for overvalued and undervalued assets, and similar comments Income statement analysis: gross profit margin, operating profit margin, trends in sales and costs, adjustments needed to truly reflect the operating profit and cash flows Ratios should be calculated and differences from the norm commented upon Analysis of the cash flow generated by the operations of the business and the prospects for repayment of the loan The adequacy of the equity of the owners in relation to the existing and proposed indebtednessQuality of the financial statements used for the analysis should be commented on. Analysis of the balance sheet, trends, needed adjustments for overvalued and undervalued assets, and similar comments Income statement analysis: gross profit margin, operating profit margin, trends in sales and costs, adjustments needed to truly reflect the operating profit and cash flows Ratios should be calculated and differences from the norm commented upon Analysis of the cash flow generated by the operations of the business and the prospects for repayment of the loan The adequacy of the equity of the owners in relation to the existing and proposed indebtedness

142. 142 Affiliation Concerns are affiliates when: One controls or has power to control A third party controls both An identity of interest exists Apple is affiliated with Affiliated Tool and Die through common ownership by Mr.. BelleApple is affiliated with Affiliated Tool and Die through common ownership by Mr.. Belle

143. 143 We Are Done!!

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